Debating the business judgment rule

Larry Ribstein —  5 October 2011

Alison Frankel gripes about a NJ judge’s ruling throwing out a shareholders’ derivative suit seeking to hold the J & J board accountable for problems concerning the company’s Rispardal drug. Frankel thinks the bad faith standard the court applied is not high enough.

Ted Frank responds that the fact that the company had settled criminal allegations doesn’t mean the board was irresponsible given big companies’ exposure to prosecutorial overreaching (here’s my thoughts on the problems with prosecutors).  He notes that given huge potential penalties and legal costs “even a risk-neutral set of executives would refuse to go to trial on criminal charges that they had a 95% chance of winning.”  As Ted says:

The issue is this: first, any corporate law is going to have to balance false negatives (valid suits against directors being thrown out prematurely) and false positives (invalid suits against directors costing tens of millions of dollars in time and money to resolve). Any opening up of the courtroom doors to challenge directors will reduce false negatives at the expense of more false positives; any increase in the burden to bring suit will reduce false positives at the expense of more false negatives.

Anyway, Ted continues, shareholders of NJ corporations can decide to invest in firms incorporated elsewhere if they think NJ law is too lenient on directors, aptly citing my and O’Hara’s The Law Market.

Of course Frankel might argue that the business judgment rule that the court used to decide the case is ubiquitous, leaving plaintiffs with little choice. Indeed, the only significant dissent is Nevada which is, if anything, even easier on directors than NJ.   Frankel might also argue that this indicates state corporation law is rigged for managers and that we would do better under federal law.  Perhaps what we need is a super Dodd-Frank/SOX on steroids that preempts state law and exposes managers to suits like the one NJ dismissed.

I would respond that the universal acceptance of the business judgment rule represents the market’s rejection of Frankel’s position.  If Frankel wants to complain that the market for corporate law is imperfect,  she would need to persuade me that shareholders are better off in the clutches of Congress.

Larry Ribstein

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Professor of Law, University of Illinois College of Law

6 responses to Debating the business judgment rule

  1. 

    Larry, you are quite right—shareholders should eat cake—like they have any rights whatsoever.

    Look at HP’s shareholders. One day you are holding a good stock and poof—same with J & J

    And selling is supposed to protect—-

  2. 

    If you don’t like management, sell the shares. Otherwise, derivative suits are a waste of everyone’s time and money.

  3. 
    northfork investor 5 October 2011 at 12:00 pm

    Larry, you could also respond that this decision might just be just another unfortunate false negative and perhaps plaintiffs should sue for J&J’s books and records to see if there is evidence of bad fatih.

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