What's the Cost of a Free Pass? A Call for the Re-Assessment of Statutes that Allow for the Elimination of Personal Liability for Directors
Tennessee Journal Business Law, Vol. 9, No. 99, 2007
36 Pages Posted: 28 Jun 2007 Last revised: 28 Feb 2012
Date Written: June 25, 2007
The 1985 Delaware Supreme Court decision in Smith v. Van Gorkom caused considerable unrest among members of corporate boards and their legal advisors. In that case, board members were held personally liable for a breach of their fiduciary duties, even though no conflict of interest existed. Many observers were taken aback by this result, and a public outcry followed. The consequences of this decision, particularly the perceived crisis in securing directors & officers liability insurance, spurred some legislatures into action. By 1986, Delaware had already enacted a statute enabling a corporation to limit or eliminate the personal liability of directors for breaches of their duty of care. Some version of this approach has now been implemented in all fifty states, and virtually all of the nation's largest corporations include these exculpatory provisions in their charters.
This Article argues that the time has come to re-examine these statutes, and that this re-examination points to a need to improve the status quo. Part I of this Article describes the Smith v. Van Gorkom holding, and the subsequent decision in Delaware to allow corporations to remove the prospect of personal liability for directors for duty of care breaches. Part II argues that these exculpatory statutes, in their current form, are doing harm to shareholders and to the orderly function of corporate law. First, this Part demonstrates that the existence and current use of the statute incentivizes board members to engage in sub-optimal behavior. Second, the Part questions the legitimacy of the original stated need for enacting the statute. Third, this Part claims that another area of corporate law, judicial interpretation of the duty of good faith, is being manipulated to circumvent the restrictions placed on courts by corporations that choose to eliminate liability for breaching the duty of care. Part III then introduces the contractarian theory of the firm in support of the current statute, examines the limitations of that theory, and explores the implications of the theory in determining the proper course of action. Finally, Part IV recommends actions available to dissatisfied shareholders, including a specific improvement in the mechanics of the statute - the addition of a requirement that shareholders must reapprove an exculpatory charter provision at least every five years.
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