Wednesday, June 9, 2010

Got Fraud? Delaware’s Corporate Paradise

It’s no secret why most corporations are incorporated in the state of Delaware or require claims against them to be brought in a Delaware court. Delaware is known for having notoriously lax standards for corporate behavior making the state courts very tolerant of corporate misconduct. In fact, the standards are so favorable to corporations, the directors and officers who played an integral role in the demise of Lehman Brothers may not be liable for their conduct because it is protected by the business judgment rule.

The business judgment rule affords limited judicial review of decisions made by the directors of a corporation under the presumption that they are acting on an informed basis, in good faith, and with an honest belief that the decisions made were in the best interest of the company. However, this presumption generally can be overcome by a showing that a director breached his fiduciary duty or a decision was a result of an irrational process. Therefore, the business judgment rule does not protect director decisions made in bad faith. In Delaware, however, the rule protects directors unless there is a showing that their actions rose to the level of gross negligence. Essentially, there is no remedy under Delaware law for nefarious conduct that is not so outrageous so as to be classified as grossly negligent.

Historically, and in most states, the business judgment rule applied only to directors of a corporation because they are held to certain fiduciary standards, unlike corporate officers. However, in a recent Delaware Supreme Court decision, Gantler v. Stephens, the state’s Supreme Court held that corporate officers and directors are bound by the same standard of fiduciary duties. Presumably, this extends the protection of the business judgment rule beyond directors to corporate officers. This conclusion is consistent with the findings of Anton Valukas, the court-appointed examiner of the Lehman Brothers bankruptcy.

Mr. Valukas penned a nine-volume, 2,200-page report on the company’s ruin. In his report, he notes the expansion of officer fiduciary duties and discusses the ramifications of Gantler, most notably, the larger umbrella of the business judgment rule in Delaware. As such, the conduct of Lehman Brothers’ directors and officers is likely insulated from liability because it does not rise to the level of gross negligence, despite alleged fraudulent transactions involving $50-billion in assets moving on and off its financial statements and the failure to heed to warnings from the company’s risk managers.

The business judgment rule and other protections from litigation for directors are necessary, but Delaware’s exceedingly lenient stance on corporate conduct may leave claimants without any recourse and provide even more incentive for companies to incorporate in Delaware.

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