Fiduciary Duties and the Business

Judgment Rule

Author: Damjan Despotovi

Master Thesis
LL.M International Business Law
University of Tilburg
July 2010

1
 Abstract

The purpose of this paper is to examine the exact contents of the fiduciary duties
of directors and managers, principally in the US. The main issue is whether current policy
on applying the business judgment rule and enforcing fiduciary duties is too lenient, in
the sense that it offers too much deference to the business judgment of corporate decision
makers. Notably, the courts seem very reluctant to review directors and managers
conduct unless there is evidence of conflict of interest. Does this abstention policy by the
courts threaten to reduce the entirety of the fiduciary duties merely to an obligation not to
self-deal? Arguably, this notion is enforced by the manager friendly legislation. The
paper tries to determine whether the balance between authority and discretion of
managers in running the company on one side, and their accountability to their principals
on the other, has been shifted in favor of the former. The paper identifies key features of
the laws governing fiduciary duties and the business judgment rule such as the duty of
good faith, procedural due care and the duty of oversight. Consequently, it analyses all of
them thoroughly, primarily focusing on the recent Citigroup case, and the approach of the
Court on all of the relevant issues that was expressed in its decision. Finally, a discussion
will follow concerning an optimal standard of care and liability, which would be effective
in catching some dangerous forms of mismanagement currently unsanctioned by
Delaware courts, and yet high enough not to allow judicial scrutiny of business decisions
to become a routine practice.

Keywords: Fiduciary Duties, Business Judgment Rule, Duty of Care, Good Faith,
Standard of Care, Standard of Liability, Oversight Duties.

2
Table of Contents

Introduction 4

Part I: Fiduciary Duties in General 6

Part II: The Business Judgment Rule 9

2.1. Origin and a Comparative Overview 9

2.2 Rationale Behind the Rule 12

2.3 The Rules Impact on Entrepreneurial Risk Taking 14
2.4 Contents of the Business Judgment Rule 16
2.5 Two Competing Understandings of the Rule 17
2.6 The Business Judgment Rule and the Procedural Duty of Care 19

Part III: Good Faith 22

3.1 The Role of Good Faith in the System of Fiduciary Duties 24
3.2 Good (Bad) Faith in the Citigroup Case and a Critical Account 27
of the Decision
3.3Problems With Proving Bad Faith 33
3.4 Subjective Sincerity Versus a More Objective Duty of Good Faith 36
3.5 Caremark analysis in Re. Citigroup 38

Part IV: Reassessing the liability standard and the business judgment rule 42
4.1 Possible Directions in Redressing the Underinclusiveness of the 44
Fiduciary Duties Laws

Conclusion 49
Bibliography 51

3
 Introduction

The issue of fiduciary duties of directors and officers, and the liability standard for
breaching them is still a very important as well as a controversial one. Its importance was
highlighted by recent major cases dealing with fiduciary duties of care and good faith, such as
Disney and Citigroup. Between them, the cases involved, among other things: bad business
decisions, enormous compensation packages, excessive risk-taking and huge losses to shareholder
capital. Just to mention some of the astonishing facts and figures that stirred up the public: Upon
leaving Disney after one year of apparently very bad performance as an executive officer,
Michael Ovitz received approximately $140 million in compensation. As a result, the decision of
the Disney board to approve a compensation package with such downside protection was
contested in trial, as well as the decision to let Ovitz go without claiming cause for terminating
the contract. On the other hand, Citigroup suffered losses amounting to more then $65 billion, as
a result of its exposure to sub-prime mortgage markets. At the same time, upon his removal from
the office CEO Charles Prince received approximately $68 million in bonuses, salaries and
accumulated stock holdings1 from the same company that was hit by such devastating losses in
the period when he was leading it.
The fact that the companies involved represented a well-known show business giant, and
arguably the biggest bank holding company in the world respectively, only added to the
controversy and increased public interest. The main issue in both cases was the level of discretion
accorded to directors and managers in exercising their business judgment, or, to put it differently,
the contents of the business judgment rule. Ultimately, the courts ruled in favor of the defendant-
directors affirming the strong concept of the business judgment rule and a high level of deference
to corporate decision-makers.2
This outcome calls for an analysis on whether US courts are being too lenient toward
corporate directors when it comes to enforcing their fiduciary duties in cases that do not involve
self-dealing. This notion is enforced by the availability of exculpation clauses, D&O insurance
and indemnification clauses that limit the potential liability even further.

1
Franklin A. Gevurtz: The Role of Corporate Law in Preventing a Financial Crisis: Reflections on In re
Citygroup Inc. Shareholder Derivative Litigation University of the Pacific (UOP) - McGeorge School of
Law (January 30, 2010) p. 33.
2
The waste claim in Citigroup is still waiting for its final epilogue, while all other claims have been
dismissed.

4
 This paper will analyze the current Delawares courts understanding of the business
judgment rule and the fiduciary duties owed by directors to the company (especially duties of
care and good faith), mostly by focusing on the application of these legal institutes in the
Citigroup case, as the most recent block buster case dealing with these issues. It will be argued
that the Court was too strict toward the plaintiffs and too reluctant to undertake any meaningful
review of the defendants conduct. In the process, it will try to critically assess whether Delaware
jurisprudence in this area is developed enough as well as doctrinally sound and consistent, or it is
in fact underinclusive in the sense that it lacks real bite in preventing some forms of
mismanagement, specifically reckless risk-taking. In addition, the paper will address important
policy considerations such as arguments pro et contra the business judgment rule, and whether
too much deference is indeed given to directors and managers due to the fear of stifling beneficial
risk-taking and subjecting them to judicial scrutiny by judges with imperfect knowledge and
potential biases, while at the same time, some other important interests are overlooked, such as
the protection of stakeholders, and the prevention of excessive risk-raking and its overall
detrimental affect.
This paper will focus mainly on Delaware corporate law because of its leading role in the
US, which resulted from the fact that the majority of the US biggest companies choose Delaware
as its venue of incorporation. In addition to the importance of Delaware law within the US, its
impact seems to stretch even further, effecting jurisdictions across the globe. Specifically,
countries like Russia or the Netherlands that are currently contemplating reforming their
corporate law and adopting some form of the business judgment rule will rely heavily on the
existing American legislation and practice due to the traditionally prominent position of the US as
a leader and a role model in this area of law. Consequently, the issues discussed in this paper have
important implications not only in the US, but also in other jurisdictions.
Finally, the paper will also provide some comparative perspective in this area of law and
discuss possible changes of direction in applying the business judgment rule and enforcing duties
of care and good faith.

5
 Part I:
Fiduciary Duties in General

One of the basic characteristics of the corporate form is the separation of ownership and
control. This means that the highest authority in managing a corporations business is the board of
directors, and not the shareholders, even though the shareholders are the owners of the
corporation3. In turn, directors are required to run the corporation for the benefit of shareholders
in an attempt to maximize the shareholder wealth. Directors and officers are agents entrusted with
power to make decisions, as only a limited number of decisions in corporate law require
shareholders consent. However, directors as agents owe a number of duties to their principal (the
corporation, and indirectly shareholders). This view of corporate governance that focuses on
shareholders as key constituents in a corporation is consistent with the concept of shareholder
primacy. However, this concept of corporate law is not uncontested in theory. One possible
alternative approach is advocated by Professor Bainbridge. Bainbridge sees the theoretical
concept of director primacy as a more appropriate and accurate frame for devising and
understanding roles of different constituents within a corporation. His model describes the
corporation as a vehicle by which the board of directors hires various factors of production4.
Notwithstanding the differences between the two concepts, and their practical implications, both
of them imply that directors have certain responsibilities to the corporation. The director primacy
model sees the authority vested in the board of directors as the key feature of corporate
governance and the tension between authority and accountability as the central problem of
corporate law5. Therefore, it does not deny the element of accountability of the board.
Having established that, we turn to the concept of fiduciary duties that is the topic of this
paper, and the essential element for understanding the idea of the directorial accountability and
liability for their actions as shareholders agents.
Fiduciary duties of directors towards the company are, in one shape or the other, present
in almost all jurisdictions. However, their scope and contents, and especially their application in

3 Unless otherwise provided by the certificate of incorporation, the directors manage the business and
affairs of the corporation (8 Del. C. Section 141 (a))
4
Stephen M. Bainbridge, The Business Judgment Rule as an Abstention Doctrine, University of
California, Los Angeles School of Law, Law & Economics Research Paper Series, p. 4. No. 03-18; He
further asserts: The board of directors is not an agent of the shareholders; rather, the board is the
embodiment of the corporate principal, serving as the nexus of the various contracts making up the
corporation.
5
Ibid

6
practice, can vary considerably. Still, if we look at laws of different countries and the way they
define fiduciary duties, we can establish some common features. Typically, two types of fiduciary
duties can be distinguished: duty of loyalty and duty of care. Both types of duties are derived
from the same idea that directors are required to advance the best interests of the company.
Therefore, these different duties are actually different aspects of one general duty. Duty of loyalty
is a remedy against self-interested behavior by directors. It basically prevents them from engaging
in appropriation of the companys assets, and using their position for their own enrichment. Or, as
the Delaware Supreme Court put it in Cede&Co. v. Technicolor, Inc,: [E]ssentially. Mandates
(duty of loyalty) that the best interest of the corporation and its shareholders takes precedence
over any interest possessed by a director, officer or controlling shareholder and not shared by the
stockholders generally6 All jurisdictions have elaborate rules that distinguish conduct that is in
breach of duty of loyalty, as well as procedures for approving and validating such transactions.
Furthermore, the bulk of the cases alleging breaches of fiduciary duty by directors and officers
that come to court deal with the breaches of duty of loyalty (illicit transactions, taking corporate
opportunities, etc.)
When we discount this type of cases, what is usually left is the duty of care and skill,
because it is widely recognized that directors need not only be disinterested when making a
particular decision or taking a course of action, but should also posses certain expertise and adopt
a certain level of care (due care). Along with the duty of care and skill, some jurisdictions also
recognize the duty of good faith. However, these duties are not nearly as developed and still
remain vague both in theory and judicial practice. Furthermore, some authors identify two
additional fiduciary duties: a duty of disclosure and a duty of special care when a company is a
target of a takeover bid. However, violations of either of these duties can be treated as either a
violation of duty of loyalty, or, absent a conflict-of-interest, duty of care7. To conclude, it is safe
to say that the duty of loyalty and the duty of care are two cornerstone fiduciary duties and all
other fiduciary duties including the duty of good faith that has been developed in Delaware, and
the duty of reasonableness in some countries, are either closely connected or derived from them.
Consequently, there are two main types of cases concerning breaches of fiduciary duties. These
types cases are indeed very much different. While courts are very determined in routing out
disloyal behavior by directors and managers, including self-dealing and insider looting, their
approach to duty of care cases is quite different, and much more cautious. Even though directors
and officers are required to exercise reasonable care in running the company (care that an
6
Cede & Co. v. Technicolor, Inc., 634 A.2d 345, at 361 (Del. 1993)
7
Bernard Black, Brian Cheffins, Michael Klausner, Outsider Director Liability, Stanford Law School
John M. Olin Program in Law and Economics Working Paper No. 250, p. 8.

7
ordinarily prudent person would reasonably be expected to exercise in a like position and under
similar circumstances)8, in practice they are never held liable by the courts unless their conduct
amounts to the standard of gross negligence.9 In addition, courts, in general, only review the
procedural aspects of the decision-making process, not the substantial quality of the decision.10
The reason why the standard of conduct and the standard of liability differ in corporate law is the
business judgment rule, which alone underlines its importance, as such a divergence is not found
in other areas of law.

Part II:
The Business Judgment Rule

8
Principles of Corporate Governance Section 4.01(1994)
9
Professor Melvin Eisenberg explains this divergence, by differentiating between the duty of care as a
standard of conduct and the business judgment rule as the standard of liability. Melvin Aron Eisenberg,
The Divergence of Standards of Conduct and Standards of Review in Corporate Law, 62 FORDHAM L.
REV. 437,444-45 (1993).
10
Troy Paredes: Too Much Pay, Too Much Deference: Is CEO Overconfidence the Product of Corporate
Governance? Washington University in St. Louis, School of Law, PAPER NO. 04-08-02 (2004), p. 81

8
 The reason the courts tend to defer to the business judgment of corporate directors is the
doctrine of the business judgment rule11. The business judgment rule is a legal standard that
underlines the basic idea that companies are run by the board of directors12, and not by the courts.
Therefore, the board is granted considerable freedom in making business decisions, and they are
generally not subjected to ex-post judicial scrutiny. The rule enables this concept of deference to
the decisions of directors and managers to work. Consequently, the business judgment rule is a
central legal institute for understanding to what extent directors and officers, as fiduciaries, are
accountable and legally liable to their principal. We will see that in Delaware, where it is
expressly recognized and vigorously adhered to by the courts, the rule substantially limits the
liability of directors and managers in the duty of care cases. It effectively creates a standard of
liability far more relaxed then the standard of care imposed on corporate decision-makers. This
standard of liability corresponds to gross negligence, as opposed to ordinary negligence, or even
something beyond that, holding personally liable only directors who failed to pay any
attention13 to the corporate issue in question.

2.1 Origin and a Comparative Overview

The origin of the rule is traced back to the case Charitable Corp. v. Sutton decided by the
English Court of Chancery in 1742. In the US it was first developed in 18th century.14 It is derived
from case law and in most jurisdictions it has not yet been codified. Its strong position in practice,
however, is beyond any doubt in the US, as demonstrated by some recent high-profile cases like
Disney, Citygroup, Oracle, etc.15 To date, in the US it is considered a common law, and not a

11
The business judgment rule is not explicitly adopted in all jurisdictions. A strong tendency of judges to
abstain from second-guessing business decisions by directors is, however, almost universal, whether or not
the business judgment rule is expressly formulated in the given countrys legislation and jurisprudence.
12
For the purpose of simplicity, I will, for now, disregard the difference between the one-tier and two-tier
board structure.
13
Dennis J. Block, Nancey E. Barton & Stephen A. Radin, The Business Judgment Rule: FIDUCIARY
DUTIES OF CORPORATE DIRECTORS, p. 167 (5th ed. 1998).
14
Dr Filippo Rossi, Making sense of the Delaware Supreme Courts Triad of fiduciary duties Studio
Legale Lombardi Molinari e associati (2005), p. 6.
15
the operative elements of the standard of judicial review commonly referred to as the BJR have been
widely recognized [and] courts have used a number of different word formulations to articulate the
concept, Fred W. Triem: Judicial Schizophrenia In Corporate Law: CONFUSING THE STANDARD OF
CARE WITH THE BUSINESS JUDGMENT RULE , Alaska Law Review Vol. 24, p. 23, (2007) , p. 13.

9
statutory rule.1617 On the other hand, United Kingdom does not have the business judgment rule,
the way it is developed in the US, except for the presumption of good faith.18 However, it has
been pointed out by the Law Commission, that the US-style business judgment rule is not
necessary, given the firmly established tradition of non-interference with business decisions in
that country.19 Therefore, the business judgment rule was not codified in the new Company Code
in 2006.
What follows is a brief overview of the legislation and judicial practice in some other
important countries, in order to establish whether an equivalent of the business judgment rule, in
some form, exists in these countries, and if the actual degree of deference to business decisions
differs from the US practice.
The corporate law reform in Germany in 2005 codified a provision that is in theory
sometimes construed as a type of a statutory business judgment rule20. Uwe Huffer contends
that this is not only a procedural rule which shifts the burden of proof to plaintiffs, but rather a
complete safe harbor.21 However, the rule in question provides that in order for a director or a
manager to be cleared from any responsibility for breaching the duty of diligence, he must be
adequately informed, and act for the benefit of the company. The scope of the standards used
(benefit of the company and adequate information) is rather vague, and is still to be
interpreted in practice and assigned a more clear meaning. In any case, though, it is hard to find
support for this interpretation in the text of the norm. It clearly posits a standard of diligent
conduct that absolves potential defendants from liability. Therefore, it requires courts to assess
the actions of directors or officers from the perspective of the duty of diligence (the German
equivalent of the duty of care). This requirement is in conflict with the business judgment rule
understood as an abstention doctrine22, since the later precludes any review of the amount of
care employed by corporate decision makers. Alternatively, if we accept the concept of the rule as

16
Ibid
17
To be sure, a formulation of the business judgment rule was adopted in the American Law Institute
restatement (AM. LAW INST. 4.01(c)) that has been adopted by three states.
18
Bernard S. Black, Brian R. Cheffins, Martin Gelter, Hwa-Jin Kim, Richard Nolan, Mathias M. Siems,
Linia Prava, Legal Liability of Directors and Company Officials Part 1: Substantive Grounds for Liability
(Report to the Russian Securities Agency) University of Texas Law School, Law and Economics research
paper no. 112 (2007) p. 69.
19
Zhen Jin: Directors Duties in the UK (2006), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=928047, page 9,10.
20
Referring to the duty of diligence: There is no violation of this duty when the member, when taking a
business decision, could reasonably be presumed to be acting for the benefit of the company on the basis of
adequate information. 93 I 2.
21
Uwe Huffer: Aktiengezetz (7th ed. 2006)., at 93, 4c,Black, Cheffins, Gelter, Kim,Nolan, Siems, Linia
Prava, Legal Liability of Directors and Company Officials Part 1 p. 45.
22
See Bainbridge, The Business Judgment Rule

10
a standard of liability, the aforementioned norm of German corporate law can be taken to
represent some sort of a business judgment rule, comparable to the one in US. Especially if the
requirement of reasonable assumption to be acting for the benefit of the company is construed
narrowly only to sanction types of conduct that are usually associated with bad faith in US
jurisprudence (knowingly and intentionally acting against the interests of the company, reckless
disregard of duties and so on). This way, the scope of discretion would be expanded, and the duty
of diligence would only be breached if directors fail to be adequately informed when making
decisions, which corresponds to the concept of procedural duty of care found in decisions of
US courts. Furthermore, it could be said to resemble the formulation of the rule found in the
restatement issued by the American Law Institute.
However, rule set forth by AktG 93 II, makes things more complex. It apparently
undermines the foundation of the business judgment rule by requiring that in cases where the
diligence of directors is called into question, it is up to them to disprove these allegations and
provide evidence that their conduct satisfied the standard of a diligent and conscientious
manager. Indeed, placing the burden of proof on directors in this type of cases seems
incompatible with the essence of the business judgment rule. As we will see, one important
purpose of the business judgment rule is to shift the burden of proof to plaintiffs in cases dealing
with breaches of fiduciary duties. This way it puts defendants (directors or officers) in a better
procedural position relative to plaintiffs. It is well recognized that procedural rules, especially
those allocating the burden of proof to parties, can have outcome-determining effects.
While it remains unclear to what extent the business judgment rule exist in Germany, it
can be concluded that German courts, even though recognizing its essential elements and
purpose23, accord a lesser degree of deference to corporate decision makers in exercising their
business judgment.24

In French corporate law there is no statutory business judgment rule. In practice,

however, courts will not hold directors and managers personably liable for ordinary negligence. A

23
Remuneration of officers is part of the executive and strategic tasks of the supervisory board and
therefore generally open to a relatively wide margin of business judgment and discretion. Accepting such a
margin of business judgment is called for because taking entrepreneurial decisions generally involves
striking a balance between possible future risks and prospectsHence no breach of duty can be found
where a decision is based on a sense of responsibility, on diligent collection of all relevant data and is
aimed solely toward furthering the companys best interests. German Federal Supreme Court in the
Mannesmann Case, BGH (Bundesgerichtshof [Federal Court of Justice]), 21.12.2005 - 3 StR 470/04, NJW
(Neue Juristische Wochenschrift) 2006 p. 522 (F.R.G. 2005). Franklin A. Gevurtz, Disney in a
.
Comparative Light University of the Pacific (UOP) - McGeorge School of Law (2007)
24
See Mannesmann and ARAG/Garmenbeck, (1997 - II ZR 175/95).

11
qualified form of negligence is required for liability to be invoked. When a decision is absurd or
obviously unreasonable (when a loan is granted even though it is obvious that it would not be
repaid25, or pursuing a sale at a loss26) liability will likely attach.
Similarly, Canadian courts had not articulated the business judgment rule as such until
recently. That changed, however, when in 2004 The Supreme Court of Canada proclaimed that
courts should apply the business judgment rule in cases involving breach of duties by directors.27
Still, the Canadian version of the rule is somewhat different from the one encountered in the
US, in that it does not preclude courts from inquiring into the merits of a given decision. As
opposed to US practice, the courts look into both the process that led to the decision and the
decision itself in determining whether the decision was reasonable in given circumstances.28

2.2 Rationale Behind the Rule

Arguments supporting this doctrine, both doctrinal and practical, are numerous in
corporate governance theory. First of all, even though directors and officers as fiduciaries of the
company and its shareholders owe a number of duties to the prior, and they are put in the office
with the main goal of increasing shareholder wealth, they are still not required to guarantee
success under all circumstances. Business decisions are often made with a lot of uncertainty and
incomplete information,29 and business success depends on many variables beyond the control of
directors, since there are many inherent risks in the business world. Therefore, directors cannot be
required to bear all of them. They are only obliged to comport to certain standards in exercising
their duties and managing assets entrusted to them. The rest of the risk stays with the shareholder
as the owners of the company.
Moreover, it is often heard that judges usually lack expertise and specialization in
business matters,30 and do not have insight into how companies are run, that would allow them to
make accurate decisions concerning business operations. This argument has a bit less merit in

25
C.A. Paris, Feb. 4, 1994, Rev. soc. 1994, at 136.
26
C.A. Lyon, 1re ch., July 5, 1984, Juris Data no. 1984-041205.
27
Peoples Dept Stores v. Wise, [2004] 3 S.C.R. 461, 491-92 (Can.).,
28
Black, Cheffins, Gelter, Kim,Nolan, Siems, Linia Prava, Legal Liability of Directors and Company
Officials Part 1, p. 64.
29
Ibid 12, page 70.
30
Judges are not business experts Dodge v. Ford Motor Co. (Mich.1919).

12
countries with specialized corporate or commercial courts and especially the state of Delaware,
which is know to have judges with good knowledge of corporate matters, and usually prior
experience as business lawyers. Also, as a counter argument, one could contend that judges lack
specific knowledge in many areas, not just business. Nevertheless, they are relied on to assess
evidence and make decisions involving complex issues, which are subjects of different fields of
science, such as medicine, forensics or engineering.31
Furthermore, a phenomenon often referred to as the hindsight bias is likely to influence
the courts perspective of a given case. Hindsight bias is a tendency to, given the benefit of
hindsight, assign a much higher probability of occurrence to events in the past, just because they
ended up occurring32, for we are inclined to believe that events that occurred ought to have
happened, and that they were much more predictable, and thus avoidable, then they actually were.
In other words: A decision that was reasonable when made may seem unreasonable in
hindsight.33 As a result, judges, if they were empowered to meritoriously revise decisions made
by directors or officers, would likely be biased toward adopting an opinion that a business move
that turned out bad, must have been a wrong move,34 which would further potentially imply
negligence and possible liability.
Another argument in support of a high level of deference to directors is that there are
constraints to directors and managers conduct other then judicial review that might be enough to
induce optimal vigilance on their part. Such mechanisms that compel them to do a better job
include labor market for managers, market for corporate control, product markets, incentive
compensation and share ownership, etc.35 However, it is hard to seriously argue that these extra-
legal mechanisms, that basically come down to market forces and reputation concerns, can totally
substitute legal rules and judicial authority.
Finally, it is often underlined that the fear of personal liability for losses caused by
negligent business decisions would be a strong deterrent for highly qualified professionals to take
up positions on the board of directors.

31
judges should find it far easier to overcome the barrier of expertise and stand in the shoes of
outside directors than in those of almost any of the other professionals whose actions courts are
routinely called upon to review Davies: Introduction to Company Law, Oxford University Press, 2002,
page 581.
32
Bainbridge, The Business Judgment Rule, p 36
33
Black, Cheffins, Clausner, Legal Liability of Directors p. 70.
34
there is a substantial risk that suing shareholders and reviewing judges be unable to distinguish between
competent and negligent management because bad outcomes often will be regarded, ex post, as having been
foreseeable and, therefore, preventable ex ante Judge Ralph Winter in Joy v. North (2d Cir. 1982).
35
Black, Cheffins, Clausner, Legal Liability of Directors p. 71.

13
 On the other hand, it is also true that the same reserves mentioned above apply to rules
establishing product liability or securities fraud liability. However, in order to protect some other
important interests these rules set forth a relatively strict liability standard. In other words, for
these types of liability directors and managers are not provided with the type of protection
parallel to the business judgment rule.36

2.3 The Rules Impact on Entrepreneurial Risk Taking

We have seen some subjective factors that are believed to make judges unfit to serve as
some kind of a second instance panel for business decisions, as well as other factors justifying a
more hands-off approach by the courts in reviewing business decisions. There is also a different
set of arguments that focuses more on how a strict judicial regime (or absence of the business
rule) would affect the behavior of directors in discharging their duties and consequently the
welfare of shareholders and the economy as a whole. For instance, it is often pointed out that
directors and managers are more risk-averse then shareholders, since some of their investments
(firm specific human capital) in the company can not be diversified away simply by acquiring a
bigger portfolio (their employment, pension plans, reputation, etc.).37 This causes them to be
more conservative when making decisions and choosing investment projects. If, in addition to
this, there is a significant risk of personal legal liability, directors will be even more risk-averse.
More valuable investment opportunities may be foregone if they involve more risk, because if a
project fails directors may be obliged to make up the loss to the corporation. If however, a project
turns out to be a success the benefits will go to the corporation, and only indirectly to directors.38
This apparent asymmetry between the upside gain and the downside risk would increase the
divergence between the interests of directors and shareholders, and potentially stifle
entrepreneurship and innovation, which would in turn harm shareholders and reduce their returns.
This observation leads to the conclusion that shareholders would actually prefer more relaxed
liability rules ex ante.39 The fact that directors and managers incentives in regard to risk-taking
can be influenced by equity based compensation can undermine the above argument to a certain
extent. In fact, these compensation schemes can create an environment where executives are

36
Bainbridge, The Business Judgment Rule, p. 29.
37
This argument clearly does not apply to the same extent to outside directors, except maybe for the
reputation part.
38
Melvin A. Eisenberg, Whether The Business Judgment Rule Should Be Codified, background study for
California Law Revision Commission (1995) p. 13.
39
Bainbridge, The Business Judgment Rule, p. 30.

14
encouraged to engage in excessively risky conduct. If performance based compensation makes up
a substantial portion of executives total earnings, and if it depends on short-term earnings
performance, which is usually the case, rational directors and managers will try to boost reported
earnings in the given period, and maximize the stock price in the short term.40 As a result, they
might resort to accounting frauds like the ones encountered in Enron and WorldCom. Similarly,
bonuses based upon earnings and stock option plans create incentives for excessive risk taking,
since unreasonable risks can increase reported earnings in the short-term.41 At the same time,
possible subsequent losses are not within their planning horizon, since there are no mechanisms
available to the company to punish financially directors and officers in accounting periods when
losses are recorded.42 In addition, they do not have to fear legal liability providing that a lax
liability regime and a strong business judgment rule are applied by the courts. This is more or less
what happened in Citigroup, since the members of the CDO department had become the
companys highest paid employees by running business operations that entailed purchasing
mortgage-based securities and repackaging them for sale. Therefore, they managed to collect
substantial pay-checks and bonuses before the sub-prime mortgage market collapsed and the
company was left with unprecedented losses. The bottom line is that directors and managers
might not be inherently risk-averse, as it is often asserted in order to justify lenient liability rules.
Note that the analysis of the effects of the business judgment rule on encouraging or
discouraging risk-taking activities by corporations was predicated upon the assumption that
liability rules should be devised in way fit to attune officers risk preferences to those of
shareholders. Notwithstanding the central role of shareholders in corporate law, the recent
financial crisis teaches us that it might be beneficial to go a step further and consider some other
constituents interests, such as those of other stakeholders and the society as a whole. In other
words, before trying to align directors and managers interests with those of shareholders it
might be wise to analyze whether shareholders understanding of acceptable risk is socially
optimal in the context of preventing similar financial breakdowns. There are at least two reasons
why these interests might diverge. Firstly, shareholders may as well be focused on short-term
gains. Since prior to the crisis the stock markets were awarding the shares of some companies that
were undertaking excessively risky investments, it is easy too see how shareholders might focus
on near-term and discount possible losses that fall outside the planning horizon.43 If they manage
to cash in on their shares before the accumulated risks materialize, subsequent losses to the

40
Gevurtz, The Role of Corporate Law p. 14.
41
Ibid.
42
Ibid.
43
Ibid

15
creditors and to the economy are merely an externality to them. Secondly, shareholders,
especially in financial institutions like Citigroup, might prefer a higher level of risk in an attempt
to achieve greater profits simply because a much greater amount of money at risk actually
belongs to creditors (depositors). Again, potential damage caused to creditors and also the tax
payers, whose money is used to bail out bankrupt banks, is an externality from their point of
view.
To sum up, we have seen some very compelling arguments in support of a strong
business judgment rule and judicial abstention. However, hardly any of them have absolute value,
as there are also some valid counter-arguments to be considered. In fact, some of the arguments in
favor of judicial abstention, even though they clearly have merit, such as the importance of
encouraging entrepreneurship and innovation through beneficial risk-taking, are often overstated
in an effort to preclude any judicial interference with how corporations are run.

2.4 Contents of the Business Judgment Rule

At this point we turn to the substance of the business judgment rule, and its role in the
legal system. The rule can be understood both as a safe harbor and as a legal presumption. It is a
safe harbor because it shields directors and officers from personal liability for some actions. The
role of the rule as a safe harbor can also be understood as a sort of a substantive, as opposed to
simply procedural presumption. This presumption is also irrebuttable, and it can be formulated in
the following way: director who is reasonably informed and acts in good faith is irrebuttably
presumed to have satisfied the duty of care.44 In effect, the rules role is to protect directors from
personal liability even when they fail to live up to the standard of care required by law. The
question what types of business decisions should be protected by the rule, and whether some
types of behavior should still be subject to liability is a difficult one, and it is the central issue in
this paper. Therefore, it will be thoroughly discussed later on.
In addition to its function as a safe harbor, the business judgment rule, in the procedural
sense, creates a legal presumption that when making a business decision directors acted with due
care, and with good faith, and no ulterior motives. Or as the Delaware Supreme Court put it: the
business judgment rule is a presumption that in making a business decision the directors of a
corporation acted on an informed basis, in good faith and in the honest belief that the action taken

44
Black, Cheffins, Clausner, Outsider Director Liability p. 12.

16
was in the best interests of the company.45 This presumption, however, is a rebuttable one,
meaning that plaintiffs can argue in court that either one of these elements relating to the conduct
of a director, does not stand in the particular case. It is up to them to prove so, though, as the
procedural role of the presumption is to shift the burden of proof from defendants to plaintiffs.
Otherwise, absent the protection of the business judgment rule, the directors would most probably
be the ones having to prove that they acted with due care and good faith in order to avoid
liability.46
As a result, as Triem put it, the business judgment rule protects corporate directors and
officers from liability for mistakes that were made in business decisions, even when such a
decision proves to have been unsound or downright erroneous47 Or, to put it differently, it
insulates directors from liability for the exercise of their business judgment absent some
exceptional circumstances like fraud or self-dealing.48

2.5 Two Competing Understandings of the Rule

Professor Bainbridge notes that there are two understandings, or two conceptions of the
business judgment rule. One understanding would be that the business judgment rule is a standard
of liability, which courts use to review the decisions of the board of directors. This is the common
understanding of the business judgment rule, and it is consistent with the shareholder primacy
model. In practice it means that the application of the business judgment rule raises the standard
of liability from simple negligence to gross negligence or that it shields directors from liability for
decisions made with good faith.49 Alternatively, courts may adopt reasonableness as an
appropriate standard of liability.50 The author himself, however, is a strong proponent of a
different approach that builds on the director primacy model and views the business judgment
rule as an abstention doctrine, which creates a presumption against judicial review of the
directors conduct. It basically insulates directors form liability in the duty of care claims,

45
Aronson v. Lewis, 812. (Del. 1984).
46
General rule in most countries civil laws is that simple negligence is presumed, and it is up to the
defendant to prove that his conduct was in fact not negligent.
47
W. Triem, Judicial Schizophrenia p. 43.
48
Ibid
49
Bainbridge, The Business Judgment Rule, p. 8.
50
it nevertheless cannot be said that their action was so unreasonable as to be removed entirely from the
realm of the exercise of honest and sound business judgment. Robinson v. Pittsburgh Oil Refining
Corporation, 126 A. 46 (Del. Ch. 1924).

17
precluding courts from making inquires into whether directors acted carelessly51 and leaving
substantive aspects of their business decisions outside of the scope of courts jurisdiction.52 A
good example of courts applying this theory is the decision of the Delaware Chancery Court in
Gagliardi v. Tri Foods Intern.,Inc. The Court stated in its decision: in the absence of facts
showing self dealing or improper motive, a corporate officer or director is not legally responsible
to the corporation for losses that may be suffered as a result of a decision that an officer made or
that directors authorized in good faith.53
According to Bainbridge, the business judgment rule should be exercised as an abstention
doctrine in order to protect the board of directors authority, shifting the balance from authority to
accountability only in cases of self-dealing and fraud54. According to this doctrine, making sure
that the authority of directors is not excessively undermined in the favor of judges or shareholders
is essential for a successful corporate governance structure.55
This paper will make an argument that the business judgment rule applied as an
abstention doctrine renders the laws on fiduciary duties ineffective in guiding directors and
managers conduct and curbing dangerous forms of corporate malfeasance.

2.6 The Business Judgment Rule and the Procedural Duty of Care

The development of the rule in Delaware, and its relation to the duty of care, suggests
that it is indeed generally used as a means to preclude courts from evaluating quality of a business
decision or its substantive aspects, limiting them to reviewing only the decision-making process.
Regardless of the outcome of a decision, liability will only attach when the procedure preceding
the decision was not reasonable (it was negligent and deficient in some way). Therefore, the duty
of care relates to the procedure used to reach a decision not the decision itself. Of course,
plaintiffs are required to prove harm to the company and causation, which means that liability,

51
the whole point of the business judgment rule is to prevent courts from even asking the question: did the
board breach its duty of care? Bainbridge: The Business Judgment Rule p. 13.
52
Ibid 23, p. 11.
53
Gagliardi v. TriFoods Intern., Inc., 683 A.2d 1049 (Del. Ch. 1996).
54
Stephen M. Bainbridge, In Defense of Chandlers Citigroup decision available at
http://www.professorbainbridge.com/professorbainbridgecom/2009/03/in-defense-of-chandlers-citigroup-
decision.html
55
Bainbridge, The Business Judgment Rule

18
will not likely be established for decisions that turn out good despite a deficient process that
spawned them. This approach was manifested in Van Gorkom, when the Delaware Supreme
Court held that directors were liable to the corporation, because they failed to exercise reasonable
care when adopting the decision to sell the company. The Court reasoned that the decision-
making process was flawed, in the sense that the defendants did not gather sufficient information
regarding the true value of the company, and consequently, were not reasonably informed before
selling it. Therefore, the amount of time spend in deliberations and the overall effort and attention
on the part of the board, were in stark contrast to the importance of the decision.56
The similar line of reasoning focusing only on procedural aspects was used in Citigroup,
the most recent major corporate case, only this time with a different outcome. One difference is
that in this case, the company had an exculpation clause included in its articles of incorporation
and, consequently, the Court was more focused on the oversight liability of directors under the
Caremark standard, since the plaintiffs were required to show indications of bad faith on the part
of directors. Only this way they would succeed in demonstrating demand futility on the grounds
that the majority of the board was facing a risk of liability. The Courts opinion demonstrated a
very high level of deference to the board of directors, as well as the reluctance of courts to
second-guess merits of business decisions, even in cases involving staggering losses and serious
indications of mismanagement. In this case, deciding upon a motion to dismiss, the Court
established that plaintiffs did not contend that Citigroup lacked procedures and controls in place,
which were designed to monitor the risk. Moreover, the company even formed a special
committee in charge of assisting the board with issues related to risk assessment and risk
management. The argument goes on to say that even according to plaintiffs own allegations, the
committee met a sufficient number of times in the relevant period. From this fact the Court
further concluded that the plaintiffs did not provide evidence that director defendants breached
their duties either because the oversight mechanisms were inadequate, or because they did not
comply with the established mechanisms.57 Therefore, since adequate procedures were in place,
and they were formally complied with, not even the fact that decisions that ensued resulted in
catastrophic losses to the company was enough for the claim to survive the motion to dismiss.58 In
support of its procedural view of the business judgment rule the Court invoked former-Chancellor

56
Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).
57
In the Court of Chancery of the State of Delaware in Re Citigroup inc. Shareholder, Civil Action No.
3338-CC Derivative Litigation.
58
Note that even if gross negligence had been established regarding the decision-making procedure, it
would not have resulted in liability for defendants, because of the statutory exculpation provision adopted
by the company.

19
Allens explanation in Caremark.59 The explanation states that degrees of wrong extending
through stupid to egregious or irrational, provides no ground for director liability, so long as
the court determines that the process employed was either rational or employed in a good faith
effort to advance corporate interests60
The same argument pertaining to the formal procedure employed in risk management and
oversight was used by the Court to dismiss claims based on the Caremark precedent, since the
Court was not convinced that the plaintiffs showed a substantial likelihood of liability of directors
for their inattention and oversight failures. We can see that the decision in Citigroup affirmed the
notion of the business judgment rule as an abstention doctrine, in the sense that it shields the
merits of business decisions from judicial scrutiny. Consequently, unreasonable, or as the Court
opinion in Caremark put it, even stupid, egregious or irrational decisions reached by a
rational procedure, and no evidence of bad faith, give no rise to liability. However, as will be
discussed later, even from a purely formalistic standpoint (leaving the outcome aside) the
oversight mechanisms in Citigroup, embodied in the ARM Committee, were well short of
desirable practice, as concluded even by relevant banking authorities.
As we have seen, there are many powerful justifications, for judicial non-interference
with the exercise of business judgment. Notwithstanding that, one could argue that this form of
the business judgment rule places to heavy of a burden on plaintiffs trying to recover monetary
damages for the company. The Court would not evaluate the quality of the decisions made, which
in this case were poor to say the least, and very costly, but only the formal procedural
requirements. In addition, they refused to use the quality of the decisions and the ignorance of the
board regarding the alleged red flags as a proxy to establishing bad faith, and thus overturn the
presumption set by the business judgment rule. In other words, the Court did not allow the theory
that the fact that, despite having a separate committee and all other necessary procedural
requirements, the board ignored these red flags and pursued a detrimental course of action
might have been a result of bad faith. Argumentum a contrario, this leads to a conclusion that the
only theory under which plaintiffs can succeed in pleading bad faith, is if they can point to a
smoking gun, showing direct evidence, for example, that directors conspired to work against

59
In re Caremark Intl Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996).
60
Caremark, 698 A.2d at 967-68 (footnotes omitted). The opinion goes on to say: To employ a different
ruleone that permitted an objective evaluation of the decisionwould expose directors to substantive
second guessing by ill-equipped judges or juries, which would, in the long-run, be injurious to investor
interests. Thus, the business judgment rule is process oriented and informed by a deep respect for all good
faith board decisions.

20
the interests of the company, or to consciously and deliberately disregard their duties.61 In the
meanwhile, potential director-defendants should be safe from liability as long as they go through
all the necessary procedural steps before adopting a decision.62

Part III:
Duty of Good Faith

At this point, we will examine in more depth the Delawares duty of good faith, before
revisiting the Citigroup case (particularly, its aspects pertaining to the institute of good faith in
relation to directors and managers conduct), as the most recent major corporate case dealing

61
This seem so be the correct way to understand the Courts insistence on particularized factual allegations
demonstrating bad faith by the director defendants.
62
Even if they do not do that, exculpatory provisions are likely to protect them from the breach of duty of
care claims.

21
with fiduciary duties and the business judgment rule. In this part an argument will be made that
this concept, the way it is developed by Delaware courts, does not offer a sufficient guidance in
cases like Citigroup, especially with regard to the standard of evidence required for disproving
the presumption of good faith. As a result, the courts tend to stick to a restrictive understanding of
this duty by not allowing recovery even in serious cases of mismanagement.
The institute of good faith is well established in Delaware corporate law. However, there
are still ongoing disputes about its role in the system of fiduciary duties, and even more
importantly, its exact contents. Whether it is understood as a separate and distinct fiduciary duty,
and one of three recognized fiduciary duties, or just as a fundamental component of the duty of
loyalty63, its current importance in corporate law is beyond doubt.
The duties encompassed by the concept of good faith exist in other countries as well,
whether they are expressly formulated under that name or not. For instance, in the UK good faith
is considered a part of the duty of loyalty.64 Therefore, bad faith, understood as a lack of good
faith, will exist if there is an improper motive or a conscious decision to deviate from pursuing
the companys best interest.65 Similarly, in Germany there is no express recognition of the
concept. However, we have already seen that 93 of the German AktG introduced the duty of
governing entities to act in the companys best interest. Serbian law is similar in this respect,
since it requires persons that owe duties to the company to, among other things, act with a
reasonable belief that it is in the best interest of the company.66 In contrast, Russian law explicitly
mentions good faith as one of the duties of governing entities within a company. It states that
directors and managers are required to act; firstly, in the interest of the company and secondly,
reasonably and with good faith.67
Good faiths prominent role in US corporate law is owed to the fact that good faith is one
of the conditions for the protection granted by the business judgment rule to be invoked.
Conversely, absence of good faith renders the business judgment rule non-applicable. In addition,
self-interested transactions can be subsequently validated by disinterested directors only if they
are acting with good faith.
The importance of the legal institute of good faith has only increased after the Model
Business Corporation Act and Section 102 (b)(7) of the Delaware General Corporation Law were
promulgated as a reaction to Van Gorkom, since many important rights of directors and managers

63
Emerald Partners v. Berlin, No. 9700, 2003 Del Ch. LEXIS 42 (Del Ch Apr. 28, 2003)
2003).
64
Black, Cheffins, Clausner, Legal Liability of Directors p. 49.
65
Ibid
66
Zakon o privrednim drutvima, Sl. Glasnik RS 125/2004. (ZOPD) (Law on Corporations) 32(2)
67
Civil Code art. 53(3) and JSC Law art. 71(1)

22
have become predicated upon the existence of good faith in their conduct. Namely, the Act,
adopted in the aftermath of the Van Gorkom case (where director-defendants were found liable
for breaching their duty of care) in order to reduce the prospects of personal liability of directors
(especially out-of-pocket liability), allows companies to adopt exculpatory statutes, further
limiting the directors and managers exposure to liability. However, while liability for grossly
negligent conduct can be eliminated, exculpation clauses are not applicable if bad faith is proven
on the part of directors. Furthermore, the legislation provides also that companies are entitled to
indemnify their directors against expenses incurred as a result of a suit or a proceeding against
them in their capacity as corporate directors, as long as they acted in good faith.68 The vast
majority of publicly traded companies have adopted such provisions limiting the liability and
allowing indemnification to the full extent permitted by law, in an attempt to attract competent
managers and directors. This development led Bishop to conclude that good faith is thus the
Achilles heel of both the business judgment rule and statutory exculpation.69
In light of this fact, it is very important to delineate conduct that runs afoul of the
fiduciary duties, but does not amount to bad faith, from bad faith conduct. Naturally, in suits
against directors or officers, as a consequence of the legislation that permits a more lenient
treatment for defendants provided that they acted in good faith, plaintiffs regularly try to assert
that bad faith was involved, while defendants tend to qualify their actions as, at most, a breach of
the duty of care, constituting negligence or even gross negligence, but not bad faith.
Some authors argue that the best way to understand good faith is to perceive it as an
excluder,70 designed to exclude many different forms of bad faith. Although this idea originated
with regard to its notion in contract law, it can, nevertheless, be applied in corporate law. A right
question to ask is: What . . . does the judge intend to rule out by his use of this phrase?71 Rather
then trying to determine the general meaning of good faith.
Therefore, according to his view, a useful starting point for defining good faith, and
determining which types of conduct fall beyond the protection of aforementioned mechanisms, is
the negative definition found in re the Walt Disney Co. Derivative Litig. The Delaware Supreme
Court used this opportunity to identify three ways in which the duty of good can be violated:

68
Del. Code. Ann. tit. 8 145(a) (2007)
69
Carter G. Bishop, A Good Faith Revival of Duty of Care Liability in Business Organization Law
research paper 07-02 (2007), Tulsa Law Review, p. 493.
70
Robert S. Summers, Good Faith in General Contract Law and the Sales Provisions of the Uniform
Commercial Code, 54 VA. L. REV. 195, 196 (1968)., Melvin A. Eisenberg, The Duty Of Good Faith in
Corporate Law Delaware Journal of Corporate Law, p. 21.
71
Ibid

23
 A director intentionally acts with a purpose other than that of advancing the best interests of
the corporation,
A director acts with intent to violate applicable positive law, or
A director intentionally fails to act in the face of a known duty to act, demonstrating a
conscious disregard for his duties.72

3.1 The Role of Good Faith in the System of Fiduciary Duties

Nevertheless, the duty of good faith is derived from the general notion that the business
of a company is run by the board of directors, and the consequent duty of directors and officers,
as agents, to always work in the best interest of the company. Different fiduciary duties merely
reflect different aspects of this duty. Therefore, the first step in understanding good faith is to
establish its relationship to the remaining two bedrock fiduciary duties; duty of loyalty and duty
of care.
Duty of care mandates directors and managers to discharge their functions in a way that
lives up to the standard of a an ordinarily prudent personin a like position and under similar
circumstances73 Therefore, the duty of care stets forth an objective standard against which
conduct of directors and managers is measured, irrespective of their motives or the state of mind.
The duty of loyalty, on the other hand, is sometimes defined narrowly and equated with the
requirement of independence (lack of self dealing or conflict of interest). Simply put, duty of
loyalty prohibits directors and officers from engaging in self-dealing.74 According to the narrow
notion of the duty of loyalty, it is confined to conducts which involve conflicting economic or
other interests75
The area not covered by the definition, and thus reserved for good faith as the third
element in the triad of fiduciary duties, encompasses conducts that involve neither pecuniary self
interest, nor they can be equated with carelessness. To put it differently, similarly to the duty of
loyalty, violations of the duty of good faith mean conscious departure from pursuing interests of
the company, acting for some other interests not related to the welfare of the company and its

72
In re the Walt Disney Co. Derivative Litig., 906 A.2d 27, 67 (Del. 2006).
73
Principles of Corporate Governance Section 4.01 (1994).
74
Rossi, Making sense of the Delaware Supreme Courts Triad of Fiduciary Duties, p. 35.
75
Ibid, p. 34

24
shareholders. However, unlike disloyalty, bad faith has other improper motives in the
background, and not personal enrichment on the companys expense.
As regards the relation of good faith to the duty of care, they can easily be conflated. In
other words, the element of good faith can be consumed by the duty of care, since it is impossible
to imagine a conducts that is consistent with bad faith (intentionally pursuing goals other then the
interests of the company, or knowing indifference towards the interests of the company) that does
not fall short of the standard of care. Actions taken in bad faith, therefore, are not actions that are
consistent with conduct of an ordinarily prudent man. However, this conflation would not be
very useful in practice, since a distinction between the duty of care and good faith is an
imperative, due to different legal consequences attached to them. In addition, bad faith is not just
a failure to employ due care, it is a more sinister transgression of fiduciary duties. The qualifying
element that sets it apart is a psychological one, since bad faith entails intent to harm the
corporation, or at least a conscious dereliction of known duties. This distinction is also what
caused the legislators in the US to set good faith as a limit, beyond which some rights are not
available to directors and officers. Therefore, bad faith can be regarded as a higher degree of
negligence that surpasses even gross negligence. Courts have started to treat some cases with
alleged inattention as cases involving not only duty of care, but also potentially bad faith, if
inattention is severe enough,76 probably in order to circumvent statutory exculpation and
indemnification clauses, as well as the overboard business judgment rule, that apply to duty of
care cases. In Disney II, for example, the Delaware Chancery Court held that facts presented by
the plaintiffs, if proven, would support claims of bad faith, due to an intentional failure to oversee
and carefully consider the conditions of Ovitzs compensation package. Consequently, a
conscious breach of the duty of care will still constitute bad faith.77
Alternatively, good faith can be consumed by the duty of loyalty as its essential
element.78 This is possible if loyalty is construed more broadly to include a positive element of
devotion (to affirmatively protect the interests of the corporation)79 in addition to the negative
requirement not to abuse a given position to expropriate companys assets.80 In this context,
observation made by Vice Chancellor Strine, who is a proponent of an approach that does not

76
Black, Cheffins, Klausner, Outside Director Liability, p. 10.
77
David Rosenberg, Supplying the Adverb, The Future of Risk Taking and the Business Judgment Rule,
Law Department of the Zicklin School of Business, Baruch College, City University of New York (2008),
p.19.
78
See Emerald Partners v. Berlin, No. 9700, 2001 Del Ch. LEXIS 20 (Del Ch. Feb 7,
2001), at 87.
79
Guth v. Loft, 5 A.2d 503 (1939), at 510, Carter G. Bishop, A Good Faith Revival p. 15.
80
Bishop, A Good Faith Revival p. 15

25
recognize good faith as a third separate fiduciary duty with an equal status, appears accurate.
Strine noted that it is inconceivable that a director can be acting in bad faith and still be deemed
loyal to the corporation. He further underlines that a fiduciary may act disloyally for a variety of
reasons other than personal pecuniary interest; and (2) that, regardless of his motive, a director
who consciously disregards his duties to the corporation and its stockholders may suffer a
personal judgment for monetary damages for any harm he causes.81 Consequently, bad faith also
necessarily entails disloyalty in its broader sense. On the other hand, bad faith is not a prerequisite
for disloyalty, since a director can, even with good intentions, violate his duty of oversight or
disclosure, mandated by the duty of loyalty to the company.82
Conversely, the majority of Delaware decisions that deal with fiduciary duties, starting
from 1993 and Cede II, endorse the notion of the triad of fiduciary duties.83 In support of this
view is also the current legislation. Delaware General Corporation Law, as we have already seen,
does not permit exclusion of personal liability fordirectors breach of the duty of loyalty to the
corporation or its stockholders84, and for acts or omissions not in good faith85 among other
things. Notably, loyalty and good faith are treated separately in this provision. However, in 2006
in Stone v. Ritter, the Delaware Supreme Court embraced the understanding of the duty of good
faith as a part of the duty of loyalty, rather then a freestanding fiduciary duty, by stating that a
failure to discharge fiduciary duties in good faith constitutes a breach of the duty of loyalty.86
We can see that Delaware jurisprudence is still wavering on the issue of fiduciary duties
between the concept of the triad of fiduciary duties and the concept of good faith imbedded in
the duty of loyalty. Nevertheless, the consequences of adopting one standpoint over the other are
merely theoretical, rather than practical, since the breach of the duty of loyalty entails the same
legal consequences as bad faith, at least in terms of (non)applicability of the business judgment
rule, statutory exculpation provision and indemnification clauses.

81
Nagy v. Bistricer, 770 A.2d 43 (Del. Ch. 2000).
82
Bishop, A Good Faith Revival p.15.
83
The Supreme Court stated that, to rebut the presumption provided by the business judgment rule, a
shareholder plaintiff has the burden of proving that directors .breached any one of the triads [sic] of their
fiduciary duty [sic]: good faith, loyalty or due care. Cede & Co. v. Technicolor, Inc., 634 A.2d, 361 (Del.
1993).
84
8 Del. C. Section 102 (b)(7)(ii).
85
8 Del. C. Section 102 (b)(7)(iii).
86
Stone, 911 A. 2d at 370. (Del. Ch. 1996).

26
 3.2 Good (Bad) Faith in the Citigroup Case
and a Critical Account of the Decision

Above we have already touched upon the Citigroup case, particularly in regard to the
understanding of the fiduciary duty of care. We concluded that the Court adopted a narrow
procedural concept of this duty, or more precisely, a rather wide understanding of the business
judgment rule as a standard of judicial review and a safe harbor, by limiting this review solely to
the formal quality of the decision-making process. Another notable characteristic of the Courts
reasoning is a very high standard of proof for establishing bad faith.
New developments in American corporate law, namely the exculpation provisions and
the limitation of the standard of review to a standard of a reasonable procedure, have created
the pressure on courts to re-qualify some traditional duty of care cases as potentially involving
bad faith, thereby expanding the concept of bad faith. The Citigroup Court refused to do so,
arguably leaving a too narrow scope of liability for the exercise of business judgment that results
in damages to the company.
Furthermore, this approach is contrary to some prior decisions, where courts dared to
examine business decisions, and not only from a procedural aspect. In the case Allaun v.
Consolidated Oil Co87 the Chancery Court went beyond simply assessing whether a rational
process preceded the decision to sale assets of the corporation. The court opined, when assessing
the adequacy of the consideration received, that for bad faith to be inferred regarding the actions
of directors, there must be a sufficient disparity between the price and the true value. Otherwise, a
presumption will attach that the disparity is a product of an ordinary mistake, rather then
improper motives, reckless indifference or deliberate disregard of the interests of
shareholders.88 The Court correctly stated that ordinary disparity does not suffice to imply bad
faith on the part of the defendants. Nonetheless, this doctrine allows inference of bad faith when a
decision is reckless or irrational. Along the same lines was the judgment in re J.P. Stevens & Co.,
Inc. Shareholders Litigation, where the Chancery Court clearly stated that courts are allowed to
review the substance of a business decision even absent self-interest. This review, however would
only serve a limited purpose of assessing whether that decision is so far beyond the bounds of

87
Allaun v. Consolidated Oil Co. 147 a.257, 261 (Del. Ch. 1929).
88
These are the elements that constitute bad faith.

27
reasonable judgment that it seems essentially inexplicable on any ground other than bad faith.89
The same type of analysis can be found in In Re RJR Nabisco, Inc90., where chancellor Allen91
concluded that true irrationality is an unlikely explanation for actions of directors of large
companies, who are presumed to have sufficient knowledge of their jobs, and are advised by
professionals. A more plausible explanation would be that what appears to be an irrational
decision, is actually a rational decision to pursue a course of action contrary to the interest of the
company and the shareholders.92
The Court in Citigroup, as we have seen took a different stand, not allowing any review
of the merits of the decisions made by defendants, not even in order to establish possible
irrationality or recklessness. In turn, the focus of the Court was solely on the procedure. As for
bad faith, the Court in this case requires a standard of proof much more difficult to meet, holding
that plaintiffs must provide particularized factual allegations demonstrating bad faith by the
director defendants, in order to excuse demand to the board of directors. In summing up
plaintiffs demands, the Court further says that the plaintiffs try to base their claims on the fact that
the company suffered large losses, and that these losses would have been avoided, had the
mechanisms designed for monitoring risk been functioning properly, and that since directors
ignored alleged red flags, they must have consciously breached their fiduciary duties. The
Court goes on to dismiss this theory as conclusory, demanding more concrete evidence. This line
of reasoning is in clear contrast to J.P. Stevens & Co. and Allaun. The Court further pointed out
the burden required for a plaintiff to rebut the presumption of the business judgment rule by
showing gross negligence is a difficult one, and the burden to show bad faith is even higher.93
Other than stating that the burden of proof on a plaintiffs, to state a claim for failure to properly
assess companys business risk, is extremely difficult, the Court did not further elaborate on
what constitutes gross negligence or bad faith, or what it is that plaintiffs need to claim or show in
order for the claim to at least survive the motion to dismiss.
The Court than concludes that Delaware law does not impose liability on directors for
failing to predict the future and to properly evaluate business risk.94 While the first part of the

89
In re J.P. Stevens & Co., Inc. Shareholders Litigation 542 A.2d 770 (Del.Ch. 1988).
90
In Re RJR Nabisco, Inc. Shareholder Litigation, C.A. No. 1039 (Del. Ch. Jan 31,
1989), at 34-35.
91
Former-chancellor Allen is obviously an authority in the field of corporate law. He is clearly regarded as
such by the Citigroup Court as well, since they quote one of his remarks from Caremark in their Citigroup
decision. However, his opinion in RJR Nabisco apparently did not appeal to them as it pretty much runs
counter to their reasoning in Citigroup.
92
Ibid at 21.
93
In Re Citigroup Inc. Civil Action no.3338-CC, p. 29.
94
Ibid, page 41.

28
statement is beyond any discussion, the second one is rather controversial, because it is a part of
the job of a director to evaluate business risk. Gross negligence by directors in performing that
duty, or not approaching it in good faith should attach liability. Moreover, in the Disney case, the
Court developed a theory of bad faith, describing it as a type of conduct when directors
consciously and intentionally disregarded their responsibilities, adopting a we dont care
about the risk attitude.95 It further asserts that knowing and deliberate indifference of directors
towards their duties also constitutes bad faith.96 Although it may be a good starting point, this
doctrine is not complete since it does not address problems with proving these subjective
elements.
Whether the facts in Citigroup suggest an ordinary mistake, or even an unfortunate
outcome without anyones fault, or gross negligence or even bad faith, is uncertain, since the
Chancery Court refused to allow plaintiffs to try and prove basis for liability. A more appropriate
approach by the Court would have been to determine whether the decisions to invest in certain
securities (or approve these investments) and approve share buy-backs were irrational or
egregious, in order to establish bad faith on the part of the defendant-directors. This, however,
does not mean that directors are liable for failing to predict future, because the decisions are not
judged only by their outcome. That would be wrong, since, as already pointed out, corporate
decision-makers do not control all factors that determine the outcome of a particular investment.
Therefore, their actions would rather be evaluated considering the circumstances in which they
were undertaken, and especially the knowledge that directors had at that moment, but also the
facts that they should have known based on their position and expertise. If decisions that were
made, observed in that light, would be deemed so far off from what would have been reasonable
conduct in those circumstances, and red flags were convincing and conspicuous enough, that
would have been a reason to infer bad faith and remove the protection of the business judgment
rule. In other words, if sufficient information was available to the directors regarding the risks of
particular business ventures, and yet they still failed to avoid it, it is possible that they breached
their fiduciary duties according to the Disney standard, by being knowingly indifferent towards
that risk, or as the Disney court put it, adopting a we dont care about the risk attitude.
Note, however, that directors are not held liable for taking on business risk, since that is a
part of their job, something they are hired to do. Still, if they assume a risk for the company that
is unreasonable in given circumstances, acting with gross negligence, while believing that they
are acting in the best interest of the company, and that the risk in question will not materialize,

95
In re The Walt Disney Company Derivative Litigation, 825 A.2d 275 (Del. Ch.2003).
96
Ibid

29
they are in breach of their duty of care. If, however, they undertake the same unreasonable course
of action with the intent to harm the company and its shareholders, or with indifference for the
possible damage, then they are acting with bad faith. Either way, the business judgment rule will
not apply as a shield from liability, and in the later case not even exculpatory clauses or insurance
against liability would be applicable. The same applies if they knowingly make decisions based
on incomplete and insufficient information.
In addition to the cases from Delaware jurisprudence mentioned above, one of the rare
codifications of the business judgment rule supports a more hands-on approach by courts. The
American Law Institutes restatement of the law of the corporation lays down conditions for the
rule to apply as a presumption of correctness and a shield from liability. A director or an officer
fulfills his duties and is, thus, provided with the protection of the rule if:
-he is not interested in the transaction (duty of loyalty)
-he is reasonably informed as to the subject of the decision (duty of care)
-he rationally believes that the business judgment is in the best interests of the
corporation97
The last condition, which can be understood as a requirement of good faith, resembles the
provision found in German law. It provides a test of good faith under which we first have to
establish subjective sincerity (he believed he was acting in the best interest of the company).
However, lack of improper motives and intent is not enough to exclude bad faith under this test.
Next step is to establish whether this belief was rational. This test entails an objective assessment
of the decision. Therefore, if there is no proof that a decision maker was acting with a motive
other then advancing the companys best interest, bad faith can still be inferred if the judge is
convinced that under the given set of circumstances the decision was irrational. This will be the
case if there were enough factors (red flags as they are referred to in the case) regarding the
subject of the decision to clearly suggest that the decision was not in the companys interest.
Clearly, Delaware courts seem reluctant to review business decisions made by directors
and managers. They are especially unlikely to hold the governing entities personally liable for
bad management absent personal pecuniary interest in a given transaction. The one duty of care

97
A director or officer who makes a business judgment in good faith fulfills the duty under this Section
[4.01] if the director or officer:
(1) is not interested in the subject of the business judgment;
(2) is informed with respect to the subject of the business
judgment to the extent the director or officer reasonably believes to be appropriate under the circumstances;
and
(3) rationally believes that the business judgment is in the best interests of the corporation
AM. LAW INST., supra note 12, 4.01(c).

30
case that resulted in director liability (Smith. v. Van Gorkom) propelled legislative reforms
designed to effectively eliminate future liability in similar duty of care cases. The main motive for
such a policy of deference and a strong business judgment rule, as already mentioned, is the fear
that otherwise beneficial risk taking would be discouraged. This argument was articulated by the
Delaware Court of Chancery in the following manner: allowing such hindsight review would
destroy the entire advantage of the risk-taking, innovative, wealth-creating engine that is the
Delaware Corporation with disastrous results for shareholders and society alike98
However, some scholars argue that such protection of virtually all risk-taking by the
business judgment rule is going too far.99 According to Rosenberg, the Delaware courts are
ignoring their own doctrine of good faith by abstaining from second-guessing decisions that
include taking risk, basically limiting the scope of the fiduciary duties of corporate directors to
nothing more than the obligation not to self-deal.100 We have seen that Delaware jurisprudence
allows a possibility of holding directors personally liable (by removing the protection of the
business judgment rule and exculpatory clauses) for types of behavior that do not involve
personal benefit for the directors, but still constitute more then just a breach of the duty of care.
This type of (mis)conduct surpasses ordinary negligence and even gross negligence. It can be
defined in a number of different ways, but the most important element is that it is action
undertaken consciously and knowingly against the interest of the company for whatever improper
motive or moral failing. In other words, directors are acting in bad faith if their not believing
that their actions are in the best interest of the company. Bad faith conduct can take a form of
either a positive action or a conscious dereliction of duty (conscious torpor).101 Simply not
caring about risks of a particular business venture is an example of bad faith. This doctrine of bad
faith was clearly expressed in Disney and again confirmed in Stone v. Ritter.
It is particularly these two cases Rosenberg refers to when suggesting that the concept of
good faith should be applied to cases where directors or managers know that the decision they are
making or authorizing is too risky102, or when they make or authorize a decision, even though
they are aware they are not informed about the subject and the potential risks.103 The author
further underlines that courts are well equipped and competent to assess behavior (including the

98
In re The Walt Disney Co. Derivative Litig. (Disney IV), 907 A.2d 693, 698 (Del. Ch. 2005).
99
Rosenberg, Supplying the Adverbp. 6.
100
Ibid
101
A term used by Chancellor Strine in Teachers Retirement System of Louisiana v. Adinioff, 900 A.2d
654, 668 (Del. Ch. 2006). For a knowing decision of a director to fail to discharge his fiduciary
obligations
102
A decision is too risky if the high amount of risk entailed in a business decision is not justified by
potential gains.
103
Rosenberg, Supplying the Adverb p. 25.

31
subjective elements) of corporate decision-makers in cases dealing with excessive risk-taking. In
addition, he stresses that this kind of judicial review would not stifle the kind of risk-taking that is
necessary for every successful enterprise, such as launching new products, expending to new
markets etc.104 Indeed, Rosenberg correctly points out that in a scenario where a board of
directors decides to invest in a project when available information suggest that the risk of failure
far outweighs possible rewards if the project is a success one need not wait to review this
decision in the hindsight of its likely failure to be able to say that the directors did not act in the
good faith belief that [their] actions [were] in the corporations best interest105
Moreover, as much as the business judgment rule was developed to encourage taking on
risks by corporation in order to increase wealth of the shareholders and the economy as a whole,
the other side of the medal should also receive due consideration. In other words, carefully
designed liability rules should protect these same interests by discouraging the type of risk-taking
that is detrimental to the shareholders and the society. This is especially important now when
economies around the world are still recovering from the events of 2008, which resulted in the
collapse of financial institutions and enormous losses, since they were at least partially caused by
reckless and unmonitored risk-taking.106
However, this argument encouraging a more active role by the courts in routing out
reckless risk-taking, even though on the right track, does not seem to be a sufficient remedy for
the current short comings exhibited in the practical application of laws governing fiduciary duties.
Even if courts were to embrace it in its entirety, plaintiffs in future cases would likely face the
same obstacles as those in Citigroup. Specifically, proving that, for instance, the defendants were
aware that they were not sufficiently informed, or that they knew that their decision was too risky.
3.3Problems With Proving Bad Faith

Thus far we have established that Delaware jurisprudence allows an inference that some
form of passivity in the face of excessive business risk is considered bad faith with all the
ramifications that this entails. Namely, if directors do not care to study all reasonably available
information in order to assess potential risks, or if they make a business decision while knowing
that the possible losses are not outweighed by potential gains. Even so, as the Citigroup case
demonstrated, the courts might not be willing to explore all potential grounds for liability to their

104
Ibid.
105
Ibid. p. 26.
106
Ibid. page 2.

32
full extent. The courts insistence throughout the text of the decision on particularized facts
alleging bad faith107, instead of inferring it from indirect evidence, was already mentioned earlier.
This stance substantially decreases the plaintiffs prospects for success, since such evidence,
pertaining directly to the director-defendants state of mind, and subjective elements such as
intention, knowledge and alike, are usually very hard to obtain.
Directors-defendants enjoy the same favorable treatment in corporate waste cases.
Notwithstanding the fact the waste claim regarding CEO Princes compensation package was the
only one to survive the motion to dismiss, the current Delaware policy on this matter is similarly
discouraging for the plaintiffs. In order to succeed they need to show that a particular transaction
was so uneven that that it cannot be reasonably regarded as fair exchange.108 However, in practice
judges are equally weary when reviewing allegedly wasteful conduct to the point that, in the
words of a Delaware judge, cases that end in a plaintiffs victory might be as hard to find as the
Loch Ness Monster.109
An alternative suggested by some other court decisions is to infer bad faith from the
defendants behavior and the decisions that they make, if they are irrational or unreasonable
enough to suggest something other then an ordinary mistake caused by mare negligence. The
potential danger is that this way the distinction between gross negligence and bad faith may be
blurred. Nevertheless, business decisions that constitute such a high degree of wrongness should
not be protected by the business judgment rule or exculpatory clauses whether or not the directors
complied with formal procedural requirements, and whether or not there are conclusive evidence
proving specific intentions, knowledge or lack thereof.
Perhaps this is a right place to point to one difference between US law on fiduciary duties
on one side, and, for instance, British and German law on the other side. Under the duty of cares
standard of conduct American directors are mandated to live up to the standard of an ordinarily
prudent person under similar circumstances. In contrast, UK law holds its directors to a more
stringent standard of care and skill by requiring that their conduct must correspond to a standard
of a reasonable person who has knowledge, skill and experience that is usually expected from
someone on a similar position with similar responsibilities, as well as general knowledge that that
director has.110 We can see that the duty of care is formulated in a way that it requires directors to

107
A plaintiff can show bad faith conduct by, for example, properly alleging particularized facts that show
that a director consciously disregarded an obligation to be reasonably informed about the business and its
risks or consciously disregarded the duty to monitor and oversee the business.
In Re Citigruop, p. 30.
108
Highland Legacy Ltd. V. Singer, C.A. No. 1566-N, 2006 WL 741393 at 7 (Del. Cha. Mar. 17, 2006)
109
Steiner v. Meyerson, 1995 WL 441999 (Del. Ch. 1995). Gevurtz, The Role of Corporate Law p. 35.
110
In Re DJan of London Ltd.(1993) B.C.C. 646

33
maintain knowledge of the companys operations and have professional skills that are expected
from a person carrying out such a function. In other words, their conduct is compared to the
presumed conduct of a professional fit to assume the position in question, rather than to that of an
ordinary prudent man. In addition, their actual knowledge and skill is also taken into account.111
This way when a bad decision is made and conduct falls well short of this standard, it is easier to
make the decisive leap and conclude that it is likely a product of an improper motive or conscious
ignorance that amounts to bad faith. This is because the standard of conduct is stricter and more
demanding then in the US. Consequently, negligence will be judged by a higher standard as well.
Similarly, bad faith, which lies beyond negligence will be easier to establish when the applicable
standard under the duty of care is more demanding.
In contrast, the Citigroup court opined that not even directors with special expertise are
held to a higher standard of care and responsibility. Consequently, the Court did not apply a
different standard of liability to directors who were members of the ARM Committee, even
though they were in charge of assessing and monitoring operational risk.112 One could argue that
common sense suggests otherwise, since those who know more are less likely to make blatant
mistakes and unreasonable decisions than those who know less and have less responsibilities.
Therefore, what otherwise could be considered an honest mistake, could serve as a proxy to
establishing a lack of good faith when experts are involved.
This observation especially has merit considering that a great portion of the companys
total losses was a result of their exposure to the sub-prime mortgage markets. Citigroup was
acquiring asset-backed securities, some of which were backed by residential mortgages, and
bundling them together in different packages in order to sell them to investors in form of
collateralized debt obligations (CDOs). This type of securities created by the bank gave investors
rights to cash flows from securities that the bank held and usually included a liquidity put.113
Initially, CDO business was very successful and created high profits. Therefore, the pressure was
increasing to even expand CDO operations and involvement in the sub-prime mortgage market.114
In the search for greater profits, business risks seemed to have been overlooked. Estimating the
amount of risk attached to the different forms of debt Citigroup was acquiring was very tricky
since it consisted of various components, some of which were less risky, while others had a

111
Alan Dignam, John Lowry, Company Law, Oxford University Press 5th edition, p. 320
112
In re Citigruop p. 34.
113
Ibid
114
Mike Neuenschwander, The Citigroup Case Study: Is Corporate Malfeasance Avoidable available at
http://hybridvigor.org/2008/11/23/the-citigroup-case-study-is-corporate-malfeasance-avoidable/

34
higher probability of default.115 Nevertheless, it was the job of directors and managers, and
especially members of the ARM Committee who are presumed to have sufficient expertise in the
field, to understand these operations and to evaluate and manage risks. The key question is
whether the gravity of subsequent losses suffered by the company, in combination with the
warning signs. suggests that those pushing for more trading with mortgage backed debt and
those who failed to recognize the risks, acted in bad faith by consciously failing to be informed
and to understand the nature of the risk of the operations they were getting into. Alternatively, we
can accept that despite the signs of worsening market conditions (red flags pleaded by the
plaintiffs), such as the steady decline of the housing market, the rise in foreclosure rates, and
several large sub-prime lenders going bankrupt,116 the director defendants believed in good faith
that approving new investments in this sector was in the companys best interest. In other words,
that the available information did not exclude a fair belief on the part of directors that investing in
residential mortgage-backed securities was still a good idea and that a failure to recognize these
risks and the subsequent collapse in the market, was nothing more than a failure to predict the
future. Indeed this is the position that the Court took when it held that even if the directors knew
of the signs of deterioration in the relevant market, or even signs indicating further decline, this
would not be enough to conclude that they were consciously disregarding their fiduciary duties to
the company.117 Therefore, the Courts position was made clear; they would not accept any other
evidence of bad faith except for direct evidence indicating the defendants state of mind.
Consequently, the case was dismissed without the Court even assessing whether the red flags
alleged by the plaintiffs were convincing enough to suggest that the detrimental course of action
was more then a simple mistake; that it is better understood as a lack of good faith on the part of
directors in discharging their fiduciary duties.

3.4 Subjective Sincerity Versus a More Objective Duty of Good

Faith

Arguably, the former approach to proving bad faith gives too much deference to the
directors and managers business judgment. It can be viewed as problematic for several reasons.
Firstly, direct evidence of what someone knew or intended to do is hard to obtain. This brings us

115
Ibid
116
In re Citigruop , p. 33.
117
Ibid, p. 35.

35
to the weak point of the Delawares doctrine of good faith. Even though it may be doctrinally
sound to distinguish bad faith behavior from negligence by putting more emphasis on subjective
elements, in practice these elements are very hard to prove, especially in the early stage of the
process. No one sensible would probably argue that intentional dereliction of duty, a
conscious disregard for ones responsibilities, or deliberately assuming excessive risks, should
be a type of conduct falling within the protection of the business judgment rule. However, when it
comes to applying these standards in practice opinions can differ substantially. As we have seen
from the Citigruop decision, more conservative courts will be inclined to approach the liability
issue very restrictively. Even if there is a strong possibility that particular conduct was
unreasonable in given circumstances, the courts might abstain from reviewing the decision,
saying that there is no direct evidence of directors bad intentions, and attributing the adverse
consequences merely to their failure to predict the future; an ability directors and managers are
clearly not required to have. Consequently, there is a real possibility that the fiduciary duties are
indeed reduced to nothing more then the obligation not to self-deal.118 This is hardly an optimal
outcome since it prevents the shareholders from recovering even in more extreme cases of
mismanagement. Furthermore, it can negatively affect other constituents within a company, as
well as the economy as a whole, by encouraging, or at least not discouraging excessive risk
taking.119
An alternative way to view this problem is that this approach seems to reduce the concept
of good faith to subjective sincerity, which may not be an appropriate regulatory framework to
guide directors and managers conduct. Apart from problems with disproving directors honesty
and sincerity, that were already discussed, another problem is that it does not address the problem
of CEO (and more broadly, all directors and managers) overconfidence. This is a type of
cognitive bias that is believed to affect corporate decision making in a way that is harmful for
shareholders and the society alike.120 According to Paredes, CEO overconfidence not only
destroys shareholder value, butharms all corporate constituencies and risks misallocating
capital away from more productive uses121 It leads managers to overestimate potential gains
from an investment, while at the same time, neglecting associated risks and costs. As a result,
companies choose project that measured by objective criteria have a negative present value.122
Therefore, we can see that if the courts focus solely on whether the decision-makers believe that

118
Rosenberg, Supplying the Adverb, p. 8.
119
Gevurtz: The Role of Corporate Law p. 9.
120
See Paredes, Too Much Pay, Too Much Deference
121
Ibid. 5.
122
Ibid

36
they are acting in the companies best interest, the business judgment rule will serve to protect
from liability even decisions influenced by self-delusion, instead of a rational evaluation of
relevant factors. There are serious indications that the Citigroup organization was a victim of such
self-delusion, when its directors and managers decided to turn the blind eye to the signs of
deterioration in the sub-prime mortgage market. Apparently, an inquiry conducted by the SEC
revealed that Citigroup decided to exclude its sub-prime mortgage holdings from its risk analysis,
because, according to a source that only agreed to speak without being named, they believed that
the risk of those mortgages defaulting was so tiny.123 If this testimony is true, is this typical we
dont care about the risk attitude that the Disney court was taking about? What this example
makes clear is that subjective sincerity or an honest belief that a particular move is in the
companys best interest is not enough to exclude bad faith. This is true for at least two reasons.
Firstly, as we have seen, that belief is hard to prove and even harder to disprove. Secondly, such a
belief may be a product of a typical cognitive bias or a perverse corporate culture within a
company, rather then based on an objective assessment of the subject matter. Therefore, a certain
qualification is necessary. For instance, according to Eisenberg, besides subjective honesty, good
faith comprises other elements. Namely, these additional conditions are: nonviolation of
generally accepted standards of decency applicable to the conduct of business; nonviolation of
generally accepted basic corporate norms; and fidelity to office.124 Similarly, this idea was
underlined by the Ohio Court in a 19th century case, where the court held that "[G]ood faith in law
. . . is not to be measured always by a man's own standard of right, but by that which [the law] has
adopted and prescribed as a standard for the observance of all men in their dealings with each
other."125 We can see that the concept of good faith has to be objectified to an extent that is
enough to prevent application of the business judgment rule to cases where it cannot be positively
established that directors knew they were working against the companys interest, or that they
consciously derelicted their know duties, but, at the same time, it is obvious that even if they
believed they were serving companys interests, their belief was objectively and rationally
unfounded. Furthermore, this argument is consistent with the ALI Restatement that only grants
the business judgment rules protection to directors and officers who rationally believe for a
particular course of action to be beneficial to the company. If the Citigroup directors and officers
indeed decided not to monitor the risk associated with their mortgage holdings, when there were
already plenty of signs to suggest that these holdings should be even more closely scrutinized,

123
Mike Neuenschwander, The Citigroup Case Study
124
Eisenberg, The Duty of Good Faith p. 26.
125
First National Bank v. F.C.Trebein Co. 52 N.E. 834, 837 (Ohio 1898).

37
there is a strong case to be made that they breached their duty of good faith to the corporation.
Even if no intention to harm the company can be found, their optimism regarding these
investments was unfounded, if not irrational, and most likely a product of overconfidence and
ignorance, or simply a refusal to face the truth. In other words, the Citigroup management
basically bet the companys future on the vast Ponzi scheme of the real estate market amid
growing signs that the scheme was unraveling.126

3.5 Caremark analysis in Re. Citigroup

One possible way of establishing liability in this case by proving that the directors were
acting in bad faith, was too show that bad faith existed in the defendants failure to implement
any reporting or information systems or controls127; or in their conscious decision not to
monitor or oversee its (the companys) operations, thus disabling themselves from being
informed of risks or problems requiring their attention.128 This doctrine was first articulated in
Caremark before it was further elaborated in Stone. According to former-Chancellor Allen, a
liability claim based on it is possibly the most difficult theory in corporation law upon which a
plaintiff might hope to win a judgment129 Indeed a very lenient approach in assessing oversight
procedures in Citigroup showed why it is so difficult to remove the protection of the business
judgment rule based on inattention.
We have seen so far that the Chancery Court assumed a very restrictive stance toward
shareholder recovery from the director defendants. Among things that made a procedural burden
on the plaintiffs very heavy is the fact that the Court effectively excluded all potential evidence
that could establishing bad faith except for those that would directly point to directors bad
motives or conscious misdeeds, which is an extremely tough procedural hurdle, especially in the
phase of trial that precedes the discovery phase. In addition, the Court adopted a very lax standard
governing directors conduct, especially in regard to directors that have specialized duties, and
who are, thus, one might think, expected to live up to a higher standard of diligence. Furthermore,
the Court endeavored only to conduct a purely procedural analysis of the directors conduct,

126
Larry Ribstein, Another perspective on Citigroup and AIG available at
http://blogs.law.harvard.edu/corpgov/2009/03/08/another-perspective-on-citigroup-and-aig/
127
Stone, 911 A.2d at 370. (Del. 2006)
128
Ibid
129
Caremark, 698 A.2d at 697. (Del. 2000)

38
ignoring the substantive quality of the actions that were undertaken. To make things even less
favorable for the plaintiffs, even this analysis under the Caremark standard was merely
superficial. The Court was content to conclude that the ARM Committee was established, and
that it met a sufficient number of times in 2006 and 2007130, and it did not go on to address some
blatant inadequacies in its structure and operation. Notably, one of the main concerns was the
lack of independence of the senior officers in charge of risk oversight from the division
undertaking the CDO operations.131 This was the result of both personal ties and inappropriate
reporting mechanisms where risk managers were at one point put in an awkward position to
report not only to the senior risk officer but also to the head of the CDO operation division, the
very same person whose risk taking they were supposed to monitor.132 The fact that traders from
the CDO team were among the companys highly paid employees, contributed to the inferior
position of those in charge of monitoring their conduct.133 As a result, the CDO department had a
clear incentive to keep up and even expand their operations never minding the possible risk, while
the risk managers, who were supposed to keep them in check, were effectively marginalized.134
Furthermore, Citigroup officials relied on positive credit ratings given to CDOs, and no
independent assessment of risk regarding the companys CDO business seems to have been
undertaken. Subsequent reports suggest that most directors and officers including CEO Charles
Prince were probably not informed enough of the magnitude of risk in these operations.135 The
accounts of Princes irresponsibility and lack of knowledge of the companys affairs are
anecdotal, as a former Citigroup executive was quoted as saying that Prince didnt know a CDO
from a grocery list136. Yet, in spite of this alleged ignorance they recklessly pushed for more
sup-prime mortgage market exposure in search of quick profits.
Ultimately, this type of behavior within Citigroup regarding risk management put the
regulators on notice, as the Federal Reserve bared the company from acquiring other financial
companies for a period of 12 months in 2005 and 2006.137

130
In Re Citigroup, p. 33.
131
Gevurtz, The Role of Corporate Law p. 6.
132
Ibid.
133
Mr. Barker drew pay totaling $15 million to $20 million a year, according to former colleagues, and
Mr. Maheras became one of Citigroups most highly compensated employees, earning as much as $30
million at the peak far more than top executives like Mr. Bushnell in the risk-management department
Neuenschwander, The Citigroup Case Study
134
Eric Dash, Julie Creswell, The Reckoning: Citigroup Saw No Red Flags Even as It Made Bolder Bets,
NEW YORK TIMES, available at http://www.nytimes.com/2008/11/23/business/23citi.html
(November 23, 2008)
135
Dash, Creswell, The Reckoning, Gevurtz, The Role of Corporate Law ,p. 7
136
Ibid, 8.
137
Gevurtz,The Role of Corporate Law p. 7.

39
 Yet, all these apparent flaws of the risk management and oversight, and even the
subsequent reaction by Federal authorities, did not convince the Court to explore the possibility
that the defendants were acting in bad faith. They simply concluded that the required mechanisms
were formally in place and that they held regular sessions. In addition, the Court brought into
question one more aspect of the complaint. Namely, whether the Caremark standard of bad faith
with regard to inattention applies likewise to the duty to monitor business risk, since in
Caremark, and later in Stone and AIG, where this standard was applied, the issue at hand was the
liability of directors for failure to oversee possible wrongdoings and illegal acts within the
company. The Court clearly drew a distinction between this type of liability and the fact pattern
in Citigroup, where only a failure to monitor excessive but legal risk-taking was alleged. The
Court opined that, even though it might seem appropriate to equate the directors duties
pertaining to business risk with their duties to oversee employee fraudulent or criminal conduct,
imposing Caremark-type duties on directors to monitor business risk is fundamentally
different138 Further on, they underlined once more the importance of preventing courts from
performing a hindsight evaluation of the reasonableness or prudence of directors business
decisions,139 and the potential of this evaluation to discourage beneficial risk-taking. Effectively,
the Court ruled that the Caremark precedent does not impose liability for omissions in relation to
overseeing excessive risk-taking.
We have seen that in the words of Chancellor Allen, this type of liability is one of the
hardest to establish. Therefore, the burden on plaintiffs is hard enough to begin with. However,
on top of that, the Court in Citigroup limited this type of liability to cases involving illegal acts by
employees giving rise to liability for the company. Again, it is questionable whether this is an
optimal solution. Firstly, it is hard to justify such a sharp distinction between the two types of
liability.140 Directors and officers are required to try and detect unauthorized conduct by
employees as well, and taking excessive risk-taking should fall outside of the authority of the
traders. Consequently, directors should be required to monitor not only wrongdoings within the
company but also business risks.141142 Secondly, this type of approach to directors liability could

138
In Re Citigroup, p. 41.
139
Ibid. page 29.
140
Gevurtz,The Role of Corporate Law, p. 30.
141
Ibid.
142
For an opinion to the contrary see: Stephen M. Bainbridge, In defense of Citigroup (the judicial
opinion, not the company), available at
http://www.professorbainbridge.com/professorbainbridgecom/2010/01/in-defense-of-citigroup-the-
judicial-opinion-not-the-company.html

40
produce undesirable incentives for the corporate decision-makers in financial institutions, as
highlighted by the recent financial crisis. It could lead to strategies focused on the short-run, since
short-term gains are enjoyed by officers through performance based compensation and stock
options, whereas the subsequent losses due to build up of excessive risk are borne by shareholders
who did not sell their shares in time, creditors and the society as a whole in case of a crisis of this
magnitude. The reason is that, as also demonstrated in the recent events in the case of Citigroup
and other companies that had similar strategies, in the short run the stock market often rewards
companies that take on more risky investments.143 As the stock price goes up the officers have an
opportunity to get rich without the fear of the downside risk when indiscriminate and reckless
investing finally takes its toll, since they are protected by very high requirements for establishing
liability for exercising business judgment and for inattention. This notion is further exacerbated
by the availability of lavish retirement packages (present both in Disney and Citigroup) that
cushion the fall of managers in case of removal from the office.

Part IV
Reassessing the Liability Standard and the Business
Judgment Rule

The Delawares law and jurisprudence on fiduciary duties are underinclusive in the sense
that they fail to sanction some forms of mismanagement that can cause great harm to a
corporation and broader economy, or in the words of Ribstein: fiduciary duties offer very little
assurance that corporate managers are actually doing their jobs144. Discussions in this paper have
pointed to some possible shortcomings of judicial control of corporate decision-making in cases
that do not involve narrowly defined conflicts of interest. In particular, courts may be too cautious

143
Ibid. 9.
144
Ribstein, Another perspective on Citigroup and AIG

41
not to undermine the authority and discretion of directors and managers by second-guessing their
business decisions. As a result, weak board oversight of risk, even while executive compensation
continued to be inflated145 has caused public discontent, especially among investors, and urged
discussion about possible solutions.
This trend of deference by the Courts can be observed in the Citigroup case by analyzing
their approach to several important issues that ultimately determined the outcome of the case. In
particular, the Courts reluctance to second-guess directors and managers business decisions is
demonstrated by its focus on procedural rather then substantial issues in reviewing corporate
decisions or establishing inattention. In addition, in the Citigroup case, even the procedural
analysis conducted by the Court was highly superficial. Consequently, it appears that any
oversight mechanisms will suffice to preserve the assumption of good faith, regardless of their
adequacy and their performance in particular circumstances. According to Brown this standard is
ridiculously high for plaintiffs seeking recovery.146
Furthermore, the Court adopted a view limiting oversight duties to employees illegal
acts and thus excluding oversight of business risk. Finally, the Courts application of the duty of
good faith similarly caused insurmountable hurdles for the plaintiffs, since the Court seemed to
demand direct evidence establishing defendants bad intentions or knowing disregard of their
duties in order to remove the protection accorded by the business judgment rule.
A lax liability standard in the duty of care and good faith cases, coupled with statutory
exculpation and indemnification clauses seems to render Delaware an extremely manager friendly
jurisdiction. Apparent downsides of this policy include: potential for excessively risky conduct,
enormously high compensations with no relation to actual performance and deference to irrational
and overconfident directors and managers. Therefore, the key issue is whether something can be
done in order to mitigate the deficiencies of the current policy without compromising important
advantages that the business judgment rule was developed to protect.
Next, we will take a look at some comparable examples in other countries and other
bodies of law in order to show that different solutions are possible, and ultimately, to try and
establish what the optimal level of accountability would be.
German law, for instance, offers an example of significantly less deference to the
business judgment of corporate directors.147 For starters, it reflects a much higher degree of

145
Stephen M. Davis, Jon Lukomnik, Business Judgment Rule: Feeling New Pressures available at
http://www.complianceweek.com/article/5219/business-judgment-rule-feeling-new-pressures-
146
J. Robert Brown, Jr. at http://www.theracetothebottom.org/home/delawares-top-five-worst-shareholder-
decisions-for-2009-2-in.html
147
Franklin A. Gevurtz, Disney in a Comparative Light, p. 2.

42
skepticism toward the ability of directors to protect the interests of the company in matters
impacting their colleagues, by mandating a two-tier board system for stock companies
(Aktiengesellschaft).148 The key distinction from the US system is the mandatory requirement that
none of the members of the supervisory board can be members of the management board at the
same time. Furthermore, as already mentioned earlier, the Stock Corporation Act (Aktiengesetz),
unlike US law, requires director-defendants to prove their due care in the duty of diligence
cases.149 In addition, as regards the issue of executive compensation, the same Act contains a
standard designed to ensure that the total amount of the compensation is in a reasonable relation
to the tasks of a particular manager and also the overall situation of the company.150 Normative
differences from the US law are sometimes highlighted even more clearly in practice, as
exemplified by the Mannesmann case. In this case, four members of the special executive
committee of Mannesmann were prosecuted criminally for the breach of trust to the company for
awarding a 10 million pounds bonus to the departing CEO Esser.151 At the end, the case finally
settled and the defendants agreed to pay 5.8 million euros in order for the prosecutor to drop all
charges.152 Clearly, the attitude towards reviewing business decisions exhibited here stands in
sharp contrast to that of Delaware courts in cases like Disney,153 especially taking into account
still considerable differences in the amounts of money at stake, and the fact that Esser was a
highly successful CEO154, whereas Ovitz and Prince, for example, were basically awarded for
their failures. Even though these cases differ in some significant features, (such as the fact that the
compensation packages in aforementioned US cases were negotiated in advance, while in
Mannesmann the bonus was awarded after the fact155) a fundamentally different policy on this
issue in two jurisdictions can be unequivocally inferred.
A significant divergence regarding the standard of liability of directors and managers can
be found even within the US. If we take a look at the securities law regulation we will see that in
this area of law directors are held liable for ordinary negligence or recklessness in preparing
proper disclosures.156 At the same time the SEC considers indemnification clauses contrary to

148
Ibid, p. 17.
149
AktG 93(2)
150
AktG 87 (1)
151
Gevurtz, Disney in a Comparative Light University of the Pacific (UOP) - McGeorge School of
Law (2007) , p. 9.
152
Ibid
153
The decision on the waste claim regarding CEO Princes compensation package in Citigroup has not yet
been reached up to date.
154
Especially so considering his contribution to negotiating the best possible take-over with Vodafone for
Mannsemanns shareholders; see Gevurtz, Disney in a Comparative Light p. 7.
155
Gevurtz: Disney in a Comparative Light p. 8.
156
Black, Cheffins, Clausner, Outside Director Liabilty, p. 63.

43
public policy.157 Yet, most arguments in favor of the business judgment rule in the fiduciary
duties cases (protecting entrepreneurship, hind sight bias, diversification and so on) apply
similarly to the securities law cases.
Even in the field of fiduciary duties, federal banking regulation imposes a stricter liability
standard. In fact, Section 1821(k) of the United States Code was enacted by the Congress due to
dissatisfaction with the state corporate law, specifically Section 102(b)(7), and its tendency to
make claims for breaches of fiduciary duties more difficult.158 It establishes gross negligence as a
necessary level of culpability for the claims against directors and officers to be successful, but it
only applies to banks in receivership and those that are bailed out by the use of funds of the
Federal Deposit Insurance Corporation (FDIC).159

4.1 Possible Directions in Redressing the Underinclusiveness of the

Fiduciary Duties Laws

So far we have seen some problems associated with the high level of discretion granted to
directors and managers in Delaware, and perverse outcomes it could produce. We have also taken
a look at some examples of more stringent liability rules imposed in similar settings. Let us now
turn to possible solutions that could push the Delaware fiduciary duties law toward a right
balance between authority and accountability of corporate directors and managers. The focus will
be on the liability standard applied by courts in the duty of care and the duty of good faith cases.
As a starting point it might be useful to first address the standard of conduct (standard of
care) of directors and managers. Even though it doesnt directly affect the standard of liability due
to the safe harbor provided by the business judgment rule, it could be a first step in introducing
more responsibility and tougher fiduciary duties. A more appropriate standard of care would
certainly be one taking into account knowledge and skill usually required for professionals
occupying positions on the board of directors or the management board, as well as the amount of
money that they are earning, instead of the one modeled after an ordinarily prudent person.
This standard would be highly contextual, as it would in practice always conform to particular
circumstances of a given case. Certainly, when applied by courts it would be flexible enough to

157
Ibid.
158
Gevurtz, The Role of Corporate Law p. 21.
159
Ibid

44
reflect different tasks and responsibilities corresponding to different positions. Therefore, under
this standard, the conduct of executives and board members would be evaluated differently due
to different duties that go with the office. Same distinction applies, for instance, to the difference
between insiders and outside directors. Similarly, members of specialized bodies (committees)
entrusted with specific responsibilities would naturally be held to a higher standard of conduct,
since they would be required to have more knowledge and exhibit more attention and vigilance in
matters within a given committees authority. As we have already seen such a standard of conduct
already exists in UK law. In addition, UK case law expressly sets forth an obligation of directors
to discharge oversight over the performance of subordinate employees to whom they delegate
some of their duties.160
Presumably, a more stringent standard of conduct would allow courts to assess the
conduct of directors more critically, notwithstanding the fact that deviating from it will not
necessarily result in legal liability. The necessity of introducing more responsibility, and a higher
level of expectations from directors and managers was recognized by E. Norman Veasey, a
former Chief Justice of the Delaware Supreme Court. In his words: [C]omplete understanding is
the key. Directors will approach their jobs in a more confident way, because they will have to
completely understand everything that is presented to them and really do their homework to get it
right. Instead of just looking at a power-point presentation, they need to understand every aspect
of a companys business and legal issues.161 The bottom line is that a new standard of conduct in
discharging fiduciary duties is needed in order for these ideas to be incorporated into US
corporate law.
Another possible amendment to Delaware corporate law addresses the way courts review
due process in making business decisions. We have already concluded that courts tend to limit
their scrutiny of business decisions on procedural aspects leaving its substantive qualities
completely aside. The same applies to cases dealing with alleged inattention of directors and
managers. However, even the procedural review seems to be strictly superficial and not
comprehensive enough in order to be efficient in sanctioning and preventing some serious types
of mismanagement. Indeed, the courts will find the breach of fiduciary duties only in the most
extreme cases, where there is virtually no consideration of a given decision or no oversight
mechanisms what so ever.162 Therefore, in order to improve corporate governance, courts could
potentially be encouraged to expand their procedural analysis to a certain extent. They should not

160
Re Barings Plc (No 5) [2000] 1 BCLC 523 at page 535.
161
Alison Carpenter, Records Inspection: Delawares Veasey Highlights Merits of Books and Records
Inspections, BNAs Corporate Accountability Report, May 21, 2004.
162
Parades, Too Much Pay, Too Much Deference, p. 84.

45
stop at simply acknowledging that the relevant bodies convened a certain number of times, but
rather inquire more deeply into the nature of deliberations preceding a decisions to try and
establish whether all important issues received due consideration under given circumstances.163
Of course, the degree of the comprehensiveness of the judicial review would be directly
proportionate to the importance of the subject of the decision. Clearly some decisions;
acquisitions, mergers, sales of important assets, and others fundamentally affecting the future of
the enterprise mandate a more stringent standard approach by the courts. Similarly, some
potential business risks should be monitored more closely if they can substantially harm a
company. A clear example is the Citigroups significant exposure to sub-prime mortgage markets
which obviously called for a more careful oversight of factors that could affect these markets and
increase the risk of default. Consequently, a tougher standard of judicial review was appropriate.
In addition, the courts should assess more skeptically whether formal procedures
employed by the company were fit to serve their purpose, which is to ensure that the process of
making business decisions and monitoring business risk is generally conducive to reaching fair
and reasonable meritorious outcomes. Again, the situation with the Citigroups ARM Committee
illustrates a situation where procedural mechanisms were formally in place but they were
established in a way that made them inherently ineffective in dealing with issues within their
authority, due to the Committees structural dependence on the people whos activities they were
supposed to monitor.
A high degree of inadequacy of the process should be enough to prove bad faith on the
part of those whose job was to make sure a reasonable system of corporate decision-making is
established.
Finally, in some cases the courts should be less hesitant to review substantive elements of
a business decision even when there is no apparent conflict of interest. This may be necessary in
order to fill the gaps in the laws governing fiduciary duties by sanctioning situations where it
cannot be positively established that defendants acted with bad intent or were conscious of the
harmful effect of their action, but the mare irrationality (from the perspective of the companys
welfare) of their conduct requires judicial intervention. The possibility of bad outcomes is
especially present in situations when, even though there is no classic conflict of interest, corporate
decision-makers are faced with somewhat skewed incentives and thus inclined to disregard the
companys best interest. As already pointed out, this may be the case when incentives in form of
performance based compensation and stock options lead managers to disregard long term
interests of the company by focusing solely on building up reported earnings in a short term time

163
Ibid.

46
frame. In the process, they tend to disregard risks that can only materialize in what is perceived as
distant future. This type of conduct, even though clearly motivated by a form of self-interest,
doesnt qualify as a conflict of interest under the law. Therefore, it doesnt violate the duty of
loyalty. In addition, in most cases the doctrine of good faith will not be effective in curbing such
behavior due to very high burden of proof that courts seem to require for proving bad faith.
Specifically, save for exceptional circumstances, there will not be direct evidence positively
proving bad intentions or that the defendants were aware that they were harming the company
and plaintiffs will be helpless in their efforts to recover their losses no matter how unreasonable
behavior of the defendants was. For all the reasons said, a suitable standard of liability in these
situations would probably be gross negligence. On the one hand, it is high enough not to deter
directors and managers from taking on business risk in general, and on the other hand, attainable
for plaintiffs in extreme cases of mismanagement. Note that the courts should not only review the
decision-making process, but also the decision itself (or a failure to monitor risk in cases of
grossly negligent inattention). The plaintiffs should be given a chance to prove that the
defendants mistakes (with regard to both the procedure and the meritorious effects) would have
been avoided had they only exhibited a very small degree of care. In turn, the defendants would
be allowed to present facts that made a particular course of conduct seem rational at the particular
moment and in the given set of circumstances. Therefore, that it would not suffice any more to
simply conclude that the plaintiffs are unable to positively prove bad faith or improper motives on
the part of the defendants. Instead, it should be established that the defendants had at least some
compelling reasons to believe their actions were in fact in the companys interest. Practically, this
would mean that either courts begin to qualify this degree of carelessness as bad faith, or that the
law is amended to the effect that exculpation clauses are no longer allowed in these
circumstances.
The same reasoning applies, and thus the same liability rule should be constructed, as
proposed by Hill and McDonnell, in the case of structural bias. This term covers a wide range
of situations where directors are inclined to favor the interests of other directors or managers,
majority shareholders, or their own, over the interests of the company, due to factors such as
personal ties, lack of independence, the pernicious golden rule164, interlocking directorships or
other similar considerations.165 Of course, structural bias only plays a role when the
aforementioned factors do not render a director self-interested in the narrow sense of the duty of

164
A situation where directors treat officers the way they would like to be treated if they were the officers.
For example in regard to executive compensation.
165
Claire Hill, Brett McDonnell, Disney, Good Faith, and Structural Bias, University of Minnesota Law
School Legal Studies Research Paper No. 06-46. p. 8.

47
loyalty, since in that case the entire fairness test would apply. The Disney case offers a good
example of an environment prone to engendering such bias on the part of the board of directors,
as a closer look at the composition of the board, specifically the members relations to the CEO
Eisner166 reveals that this was hardly a kind of a board that would always critically and
objectively assess Eisners actions.

Conclusion

This paper intended to critically analyze the current policy in applying the business
judgment rule and enforcing the fiduciary duties of directors and managers. The business
judgment rule was developed to protect corporate decision makers from personal liability for the
decisions business they make save for exceptional circumstances, and corporations from
excessive judicial interference in their business affairs. Furthermore, it serves to protect
entrepreneurship and keep quality candidates on the job market for managers. Notwithstanding
this backdrop, the current jurisprudence in this area seems to suffer from serious deficiencies. We
have seen that US courts exhibit a very strong tendency to restrict themselves to a very limited
review of business decisions even in situations where there are serious indications of extreme
cases of mismanagement. As a theoretical underpinning for this approach they use the doctrine of
the business judgment rule. Indeed, some recent court decisions are consistent with the
understanding of the rule as an abstention doctrine designed as filter for fraud and self-

166
See in Re Walt Disney Derivative Litigation, 731 A.2d 342, 356-62 (Del. Ch. 1998).

48
dealing.167 Consequently, shareholders seeking compensation who are unable to meet a difficult
task of proving that defendants intentionally harmed the corporation face a certain prospect of
losing at trial.
This concept is premised on the notion that directors and managers are generally both
rational and motivated to pursue the best interest of the company when making business
decisions. Therefore, if improper motives cannot be proven, business decisions should be
tolerated irrespective of their outcome. However, in some situations directors and managers may
be compelled to pursue actions that do not serve their narrowly defined self-interest, but are still
harmful to the company. This will be the case when factors like performance based
compensation, structural bias or cognitive biases directors and managers are susceptible to,
provide perverse incentives. Furthermore, subjective bad faith is extremely difficult to prove in
court, especially in an early stage of the process. Consequently, laws on fiduciary duties seem
ineffective in filtering some important forms of mismanagement (including reckless risk taking
that was by all accounts present in the case of Citigroup). Specifically, cases where directors and
managers do a terribly bad job, and at the same time the background of their actions was
conducive to these types of failures, in the sense that it provided incentives to disregard the
interests of the company to some extent.
To try and mitigate these apparent shortcomings relevant laws might need to be adjusted
to the effect that a higher standards of conduct and liability are applicable to corporate decision-
makers. On their part, the courts should undertake to conduct a more meaningful review of
business decisions and cases of inattention. In particular, a more comprehensive review of the
procedure as well as of the meritorious effects of a given course of action may be in order.
Specifically, even if the possibility that the defendants acted with subjective good faith cannot be
fully excluded, personal liability should attach in some cases. Clearly, subjective belief or honesty
should not be the only measurement of good corporate governance. Also, subjective elements are
extremely difficult to prove or disprove.
Therefore, the duty of good faith should be expanded to include some objective elements
to ensure that the subjective belief is supported by at least some firm reasons. If a particular
action is unreasonable in the sense that available information at the time presented enough
compelling arguments against it, and virtually none in favor, defendants should not be allowed to
escape liability only on the grounds that they were not aware of the harmful effects of their
conduct. Alternatively, instead of objectifying good faith, the same effect could be achieved by

167
Bainbridge, In Defense of Chandlers Citigroup decision

49
adopting gross negligence as a relevant threshold that sets apart types of conduct that can trigger
personal liability. Similarly, conduct that falls significantly short of the standard of care of
directors and officers will be sanctioned. Practically, it would mean abolishing the provision of
the Delaware Code that allows exculpatory clauses applicable to grossly negligent behavior. This
does not even seem to be such a controversial reform, since purely intuitively it does not appear
right to absolve directors, who are highly paid and esteemed professionals, from responsibility for
damages that stems from such forms of mismanagement that even amount to the high standard of
gross negligence.
Some of these amendments to the current laws and jurisprudence could be a step toward
achieving a right balance between authority and responsibility of corporate actors. However, the
standard of liability should remain high enough not to allow judicial second-guessing of business
decisions to become a routine practice. Instead, it should only be reserved for extreme cases of
mismanagement.

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