In the first weeks of 2013, the Delaware courts have already twice addressed a fundamental issue of corporate governance: the deference owed to directors when making business decisions and performing their fiduciary duties. The two opinions are arguably at tension with each other, however, with the earlier opinion by the Delaware Court of Chancery allowing a claim of bad faith against the board to continue and the later opinion of the Delaware Supreme Court upholding the dismissal of a challenge against a board's compensation planning. This Article briefly reviews the primary ruling in each decision and attempts to reconcile their seemingly different approaches to board deference.

On January 14, 2013, the Supreme Court in Freedman v. Adams, et al. upheld an earlier ruling of the Court of Chancery holding that a stockholder-plaintiff failed to state a claim for corporate waste in a derivative complaint brought against XTO Energy Inc. and its board of directors ( (Del. Jan. 14, 2013) and see Legal Update, Delaware Supreme Court: Board Decision to Sacrifice Tax Savings Not Corporate Waste). The complaint had alleged that the board's decision to pay $130 million of cash bonuses to certain officers without adopting a plan that could have made those payments tax deductible under Section 162(m) of the Internal Revenue Code caused a loss of $40 million in wasted tax savings.

In the complaint, the plaintiff argued that the board's failure to approve a Section 162(m) plan was "irrational" under the formulation in Disney for a finding of corporate waste and therefore enough to deprive the board of the protections of the business judgment rule (see In re the Walt Disney Company Derivative Litigation, 906 A.2d 27, 74 (Del. 2006)). According to the Supreme Court, however, the board's decision to forego attempting to qualify for tax savings under Section 162(m) to retain flexibility when making compensation decisions was a "classic exercise of business judgment." Therefore, the Supreme Court found that even though the decision to not adopt a Section 162(m) plan may have been a poor one, it was not unconscionable or irrational. The board of XTO Energy was therefore still entitled to the protections of the business judgment rule.

Earlier in the month, the Court of Chancery in In re Novell, Inc. Shareholder Litigation denied in part a motion to dismiss brought by the defendant directors of target company Novell, Inc., Novell's buyer, Attachmate Corporation, and a minority stockholder of Novell, Elliott Associates LP ( (Del. Ch. Jan. 3, 2013) and see Legal Update, In re Novell: Delaware Court of Chancery Finds Potential Bad Faith by Target Board). The class-action case arose from the sale of Novell in November 2010 to Attachmate (for a summary of the merger agreement in that sale, see PLC What's Market, Attachmate Corporation/Novell, Inc. Merger Agreement Summary). The plaintiffs had accused the Novell board of knowingly favoring Attachmate during the sale process, even as Novell received comparable, if not better, offers from another bidder. The Novell board had seemingly ignored those offers and withheld valuable information from the bidder that it shared with Attachmate.

Because, at the pleading stage, the defendants had not offered any evidence to explain why they apparently and improperly favored Attachmate, the Court of Chancery denied their motion to dismiss. In so doing, the Court said that for purposes of a motion to dismiss, the plaintiffs had made a "reasonably conceivable" claim that the board had not only breached its duty of care, but had done so in bad faith, therefore denying the directors the benefit of the exculpation provisions of Novell's charter.

Shortly after these two decisions were issued, Professor Lawrence Hamermesh of Widener's Institute of Delaware Corporate & Business Law questioned on his blog whether these two decisions can be reconciled. Professor Hamermesh essentially asks how the two courts could come to such different conclusions about the board's entitlement to deference when, in both instances, the boards barely offered any explanations for their respective rationales beyond insisting on their right to exercise their business judgment.

As Professor Hamermesh notes, the Freedman opinion does not indicate that the XTO Energy board ever explained its reasons for not adopting a Section 162(m) plan. The board simply directed the plaintiffs to the company's proxy statement, which only stated that the board's compensation committee understood the potential tax deductions available under Section 162(m) and nevertheless determined that its compensation decisions should not be constrained by attempts to qualify for those deductions. This was apparently enough for the Supreme Court. Yet, in Novell, when the board did not offer an explanation for why it favored Attachmate over the third-party bidder, the Court of Chancery concluded that for that reason, it could not ignore the possibility of a breach committed in bad faith.

As Professor Hamermesh said, "It's challenging to think of a doctrinal structure in which these two opinions can co-exist."

The remainder of this Article attempts to meet that challenge. However, whether or not the cases can be distinguished on a doctrinal basis, attorneys who must advise directors of their fiduciary duties should recognize the difference between the two underlying scenarios. This, at a minimum, can help them predict how a Delaware court may analyze a similar factual situation.

While reasonableness seems like little to ask of a board of directors, it surpasses the standard applicable in ordinary decision-making situations, under which the board merely must act rationally. This flows from the presumption of the business judgment rule, which is rebutted if the plaintiff can demonstrate that the board acted in bad faith.

Short of demonstrating a conflict of interest, a plaintiff reveals the board's bad faith only if it shows the board to have acted irrationally. But even this rationality standard does not contemplate substantive review of the board's underlying business decision. A board is said to have acted rationally if it simply pursued a "rational business purpose" (a phrasing first used by the Supreme Court in Sinclair Oil Corporation v. Levien, 280 A.2d 717, 720 (Del. 1971)).

The distinction between reasonableness and rationality may seem more theoretical than practical. Yet the Court of Chancery has recognized and emphasized this distinction. In Netsmart, then-Vice Chancellor Strine said:

The wording of the Supreme Court's decision in Freedman and the Court of Chancery's decision in Novell bear this distinction out. In Freedman, the Supreme Court analyzed the board's compensation decision-making against the standard for corporate waste pronounced in Disney. Under Disney, "[a] claim of waste will arise only in the rare, unconscionable case where directors irrationally squander or give away corporate assets" (Disney, at 74).

As the Supreme Court explained in Disney, the appeal to the rationality standard for a finding of corporate waste is not coincidental. On the contrary, it is an "onerous standard" that is "a corollary of the proposition that where business judgment presumptions are applicable, the board's decision will be upheld unless it cannot be attributed to any rational purpose" (Disney, at 74).

The plaintiff in Freedman apparently understood this well, arguing that it was "irrational for a corporate board of directors not to have a stockholder-approved, objective, performance-based compensation plan." But the Supreme Court rejected this assertion, explaining simply that the board was "aware of the tax law at issue" and decided that the company would still be better off without adopting the plan. That finding alone defeated any claim that the board was ill-informed. The Court added that the board believed that a Section 162(m) plan would constrain the compensation committee in its determination of appropriate bonuses. With that, the Court found that the board had acted in pursuit of a rational business purpose. The good-faith prong was therefore met as well.

With no facts left to rebut the presumptions of the business judgment rule, the Supreme Court immediately ruled that the board's decision was a "classic exercise of business judgment." It did not need the board to present any explanation for how it reached its decision. Any demand of that nature would have amounted to a substantive inquiry into the merits of the board's decision.

In Novell, by contrast, the board was well within Revlon mode. This meant that the directors were not entitled to a standard of mere rationality, but of reasonableness. Generally, to state a claim for breach under Revlon, a plaintiff must prove both that the board:

In a case where a plaintiff alleges deliberate favoritism on the part of the board, the underlying facts often prove both prongs. This was the argument in Novell, where the plaintiffs made reasonably conceivable claims that the board, in favoring one bidder over another:

Facing a credible argument that it had not acted reasonably, the Novell board could not decline to present any redeeming facts. It did not enjoy the presumptions of the business judgment rule and its decisions were subject to substantive review. It therefore had to make some factual assertion to explain its conduct.

As the Court of Chancery explained, it would not necessarily have taken all that much for the board to have demonstrated that it had acted reasonably. It could have:

However, the record contained no facts (at the pleading stage) to support any of these responses. It therefore followed that the Court of Chancery had to deny the board's motion to dismiss.

To the extent that the distinction between rationality and reasonableness seems thin, practitioners should keep a broader point in mind. In an ordinary situation of business judgment, the board balances each of its decisions against a host of company-specific, industry and economic factors, all of which generate their own unique considerations. Consequently, every decision the board makes can be compared in hindsight against a limitless set of possible alternatives. This makes it altogether sensible for a court to decline to revisit a board's business decision on the merits.

In a Revlon situation, on the other hand, the court focuses on a much narrower set of facts and circumstances. All the possible alternatives for stockholder-wealth maximization fall away, with all the attention paid to the sale and the process that led to it. In that scenario, whether or not one accepts that there is a great deal of difference between rationality and reasonableness, it should not be surprising if a court can find it that much easier to find fault with the process.