In Praise of Procedure: An Economic and Behavioral Defense of Smith V. Van Gorkom and the Business Judgment Rule

30 Pages Posted: 25 Nov 2001  

Lynn A. Stout

Cornell Law School - Jack G. Clarke Business Law Institute

Date Written: September 27, 2001

Abstract

The business judgment rule is one of the most puzzling and widely-criticized doctrines in corporate law. As described in Smith v. Van Gorkom, the rule prohibits courts from second-guessing the wisdom of disinterested corporate directors' substantive decisions. Instead, courts may consider only the quality of the boards' decisionmaking process and particularly whether the board "informed" itself before taking action. This focus on procedure seems dysfunctional from a rational choice perspective. If directors are rational and self-interested actors, imposing liability on them for following shoddy procedures does not in itself give them incentive to exercise due care. It only gives them incentive to adopt more elaborate, and more expensive, procedures.

In this essay I argue that the business judgment rule can be understood if we are willing to modify the "homo economicus" model of human behavior that underlies rational choice analysis to take account of the reality of socially contingent altruism. Extensive empirical evidence demonstrates that altruistic behavior is both a common and a predictable phenomenon. In particular, numerous studies of behavior in experimental social dilemma games demonstrate that altruism is easily triggered by social context (e.g., subjects' beliefs regarding others' needs, expectations, or behavior). These studies also demonstrate, however, that altruistic behavior tends to diminish as the personal sacrifice involved increases.

This last finding suggests that the business judgment rule can be best understood as a mechanism for encouraging director altruism, in the form of a sense of obligation to the firm and its shareholders, by reducing the marginal personal costs associated with altruistic director behavior. In particular, I argue that the rule (1) reduces directors' marginal "cost of comprehending" what is going on at the firm and what the likely consequences of alternative courses of action might be, and (2) reduces directors' marginal "cost of confronting" the firm's managers to demand more information or to challenge a management-recommended course of action. The result is that the business judgment rule's procedural focus may provide an elegant, second-best solution to the problem of encouraging director care in situations where courts cannot assess the substantive wisdom of directors' decisions.

JEL Classification: D64, G34, K22, L2

Suggested Citation

Stout, Lynn A., In Praise of Procedure: An Economic and Behavioral Defense of Smith V. Van Gorkom and the Business Judgment Rule (September 27, 2001). UCLA, School of Law Research Paper No. 01-21. Available at SSRN: https://ssrn.com/abstract=290938 or http://dx.doi.org/10.2139/ssrn.290938

Lynn A. Stout (Contact Author)

Cornell Law School - Jack G. Clarke Business Law Institute ( email )

Myron Taylor Hall
Cornell University
Ithaca, NY 14853-4901
United States
607-255-8431 (Phone)

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