Business judgment rule

A regulation that helps to make sure a corporation’s board of directors is protected from misleading allegations about the way it conducts business. Unless it is apparent that the board of directors has blatantly violated some major rule of conduct, the courts will not review or question its decisions or dealings.

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The reason for this rule is to acknowledge that the daily operation of a business can be innately risky and controversial. Therefore, the board of directors should be allowed to make decisions without fear of being prosecuted. The business judgment rule further assumes that it is unfair to expect those managing a company to make perfect decisions all the time. As long as the courts believe that the board of directors acted rationally in a particular situation, no further action will taken against them.

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Deference given by courts to the Good-Faith operations and transactions of a Corporation by its executives. Reasonable decisions, even if not the most profitable, will not be disturbed by a court upon application by a disgruntled party such as a Stockholder. The rationale behind the rule is that stockholders accept the risk that an informed business decision, honestly made and rationally thought to be in the corporation's best interests, may not be second-guessed. Therefore, courts afford business judgments special protection in order to limit litigation and avoid judicial intrusiveness in private-sector business decision making.

A legal principle that makes officers, directors, managers, and other agents of a corporation immune from liability to the corporation for loss incurred in corporate transactions that are within their authority and power to make when sufficient evidence demonstrates that the transactions were made in good faith.

The directors and officers of a corporation are responsible for managing and directing the business and affairs of the corporation. They often face difficult questions concerning whether to acquire other businesses, sell assets, expand into other areas of business, or issue stocks and dividends. They may also face potential hostile takeovers by other businesses. To help directors and officers meet these challenges without fear of liability, courts have given substantial deference to the decisions the directors and officers must make. Under the business judgment rule, the officers and directors of a corporation are immune from liability to the corporation for losses incurred in corporate transactions within their authority, so long as the transactions are made in good faith and with reasonable skill and prudence.

The rule originated in Otis & Co. v. Pennsylvania R. Co., 61 F. Supp. 905 (D.C. Pa. 1945). In Otis, a shareholder's derivative action alleged that corporate directors failed to obtain the best price available in the sale of securities by dealing with only one investment house and by generally neglecting to "shop around" for the best possible price, resulting in a loss of nearly half a million dollars. The federal district court ruled that although the directors chose the wrong course of action, they acted in good faith and therefore were not liable to the shareholders. The court reasoned that "mistakes or errors in the exercise of honest business judgment do not subject the officers and directors to liability for negligence in the discharge of their appointed duties."

More recently, the business judgment rule has been applied to directors' actions when corporations are faced with a hostile takeover. In Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. Super. 1985), the Delaware Supreme Court upheld the defensive actions taken by a board of directors during a takeover struggle with a minority shareholder. In this case Mesa Petroleum Company made an offer that would have made it the majority shareholder in Unocal Corporation. Under the offer shareholders who sold their Unocal stock would receive $54 a share until Mesa acquired the 37 percent it sought, and then would receive highly speculative Mesa securities instead of cash for any stock sold beyond that 37 percent. To counteract the takeover bid Unocal's directors announced that if Mesa obtained 51 percent of its shares, Unocal would purchase the remaining 49 percent for an exchange of debt securities (securities reflected as debt on the books of the corporation) with an aggregate par (or face) value of $72 a share, but the offer would not be extended to the 51 percent of stock held by Mesa. Mesa filed suit, alleging that the directors had violated their fiduciary duty by excluding Mesa from the exchange. The court concluded that the directors' actions were protected by the business judgment rule. The court recognized that in responding to hostile takeover bids the directors of a corporation can face a conflict between their own interests and the interests of the corporation and its shareholders. The court stated that the Unocal directors had reasonable grounds to believe that a danger to the corporation existed because of Mesa's actions, and that the defensive actions they took were reasonable in relation to the threat they "rationally and reasonably" believed the offer posed.

Despite the seemingly broad scope of the business judgment rule, corporate directors have not always been able to rely upon it as a way to escape liability for their actions. In Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), the Supreme Court of Delaware held that the directors of a corporation failed to exercise informed business judgment and instead acted in a grossly negligent manner by agreeing to sell the company for only $55 a share. The court looked to evidence indicating that the directors reached their decision to sell at that price after hearing only a twenty-minute oral presentation concerning the sale. The court also noted that the directors had received no documentation indicating that the sale price was adequate and had not requested a study to help them determine whether the price was fair. Although the directors were not accused of acting in bad faith, the court stated that the directors' fiduciary duty toward their shareholders required more than merely an absence of bad faith. The directors, according to the court, had an affirmative duty to protect the shareholders by obtaining and reviewing information necessary to help the directors make sound business decisions. By failing to inform themselves they were therefore liable to the shareholders for their bad business decision.

Even when a corporation faces a hostile takeover, the business judgment rule may not insulate its directors from liability. In Revlon v. MacAndrews & Forbes Holdings, 506 A.2d 173 (Del. 1985), the company attempting a takeover sought a preliminary injunction to prevent the corporation that was the target of the takeover from granting a lockup option, which gives a friendly third party the right to purchase part of the target company to help thwart a takeover. The Delaware Supreme Court held that the directors failed to fulfill their duty to preserve the company by not maximizing the sale value of the company for the benefit of its shareholders. According to the court, by instituting the lockup option and halting the bidding, the directors allowed "considerations other than the maximization of shareholder profits to affect their judgment" and thus acted to the detriment of the shareholders. Once the directors determined to sell the corporation, the court held, their role changed from that of "defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at the sale of the company." As a result, the court held that the directors were not entitled to the protection of the business judgment rule.

Courts have further held that the business judgment rule will cover the actions of directors only where the directors are disinterested and independent with respect to the action that is at issue. A director is independent when she or he is "in a position to base [her or his] decision on the merits of the issue rather being governed by extraneous considerations or influences"; conversely, a director is considered to be interested if she or he appears to be on both sides of a transaction or expects to derive personal financial benefit from it, as opposed to a benefit to be realized by the corporation or all shareholders generally (Aronson v. Lewis, 473 A.2d 805 [Del. 1984]). Thus, if one director stands to receive a substantial financial benefit from the issuance of stock nonetheless designed to counteract a takeover threat, the business judgment rule may not apply to the board of directors' actions. Such allegations of bias, lack of independence, or disinterest must be supported by tangible evidence.

See: immunity; negligence.

The business judgment rule is an American case law-derived concept in corporations law whereby the "directors of a corporation . . . are clothed with [the] presumption, which the law accords to them, of being [motivated] in their conduct by a bona fide regard for the interests of the corporation whose affairs the stockholders have committed to their charge"^[1] and whereby a court will refuse to review the actions of a corporation's board of directors in managing the corporation unless there is some allegation of conduct that the directors violated their duty of care to manage the corporation to the best of their ability. The burden is on the party challenging the decision to establish facts rebutting the presumption.^[2]

Contents 1 Basis for business judgment rule 2 Duty of Care and Duty of Loyalty 3 Standard of Review 4 Rationale 5 See also 6 Notes 7 External links

Basis for business judgment rule

Companies law

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United States

S corporation · C corporation LLC · LLLP · Series LLC Delaware corporation Nevada corporation Massachusetts business trust

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Contract · Civil procedure

v • d • e

Given that the directors are not insurers of corporate success, the business judgment rule specifies that the court will not review the business decisions of directors who performed their duties (1) in good faith; (2) with the care that an ordinarily prudent person in a like position would exercise under similar circumstances; and (3) in a manner the directors reasonably believe to be in the best interests of the corporation.^[3] As part of their duty of care, directors have a duty not to waste corporate assets by overpaying for property or employment services. The business judgment rule is very difficult to overcome and courts will not interfere with directors unless it is clear that they are guilty of fraud or misappropriation of the corporate funds, etc.^[4]

In effect, the business judgment rule creates a strong presumption in favor of the Board of Directors of a corporation, freeing its members from possible liability for decisions that result in harm to the corporation. The presumption is that "in making business decisions not involving direct self-interest or self-dealing, corporate directors act on an informed basis, in good faith, and in the honest belief that their actions are in the corporation's best interest."^[5] In short, it exists so that a Board will not suffer legal action simply from a bad decision. As the Delaware Supreme Court has said, a court "will not substitute its own notions of what is or is not sound business judgment" ^[2] if "the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company." ^[6]

Duty of Care and Duty of Loyalty

Although a distinct common law concept from duty of care, duty of loyalty is often evaluated by courts in certain cases dealing with violations by the board. While the business judgment rule is historically linked particularly to the duty of care standard of conduct,^[7] shareholders who sue the directors often charge both the duty of care and duty of loyalty violations. This forced the courts to evaluate duty of care (employing the business judgment rule standard of review) together with duty of loyalty violations that involve self-interest violations (as opposed to gross incompetence with duty of care). Violations of the duty of care are reviewed under a gross negligence standard, as opposed to simple negligence. Consequently, over time, one of the points of review that has entered the business judgment rule was the prohibition against self-interest transactions. Conflicting interest transactions occur when a director, who has a conflicting interest with respect to a transaction, knows that she or a related person is (1) a party to the transaction; (2) has a beneficial financial interest in, or closely linked to, the transaction that the interest would reasonably be expected to influence the director's judgment if she were to vote on the transaction; or (3) is a director, general partner, agent, or employee of another entity with whom the corporation is transacting business and the transaction is of such importance to the corporation that it would in the normal course of business be brought before the board.^[8]

Standard of Review

The following test was constructed in the opinion for Grobow v. Perot, 539 A.2d 180 (Del. 1988), as a guideline for satisfaction of the business judgment rule. Directors in a business should:

• act in good faith;
• act in the best interests of the corporation;
• act on an informed basis;
• not be wasteful;
• not involve self-interest (duty of loyalty concept plays a role here).

Rationale

Under the Delaware General Corporation Law, the business judgment rule is the offspring of the fundamental principle, codified in Del. Code Ann. tit. 8, § 141(a), that the business and affairs of a Delaware corporation are managed by or under its board of directors. In carrying out their managerial roles, directors are charged with an unyielding fiduciary duty to the corporation and its shareholders.^[9] The rationale for the rule is the recognition by courts that, in the inherently risky environment of business, Boards of Directors need to be free to take risks without a constant fear of lawsuits affecting their judgment.^[10]

The presumption raised by the Business Judgment Rule may be rebutted by the plaintiff. "The business judgment rule is a presumption that in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Thus, the party attacking a board decision as uninformed must rebut the presumption that its business judgment was an informed one."^[9] Further, rebuttal typically requires a showing that the defendants violated duty of care or loyalty (with courts assuming director's good faith otherwise). If the plaintiff can show that an action should not be protected by the business judgment rule (such as when a director decides to give over a certain percentage of the company's profits to charity (duty of care violation) or lines his/her own pockets with company's money (self-interest/duty of loyalty violation)), then the burden will shift to the defendant to show that the action meets the burden of good faith/rational decision. In many cases, it is relatively easy for a director to find some rational reason for his actions and, with the courts using the business judgment rule, the case will likely be dismissed (U.S. courts disdain getting involved in business matters).

Frequently, the winning cases for plaintiffs involving the business judgment rule involve acts constituting corporate waste. Also, note that some Board decisions lie outside the business judgment rule. For instance, in the takeover context, courts will apply the more stringent Unocal test, also called intermediate scrutiny.

One of the earliest cases, Dodge v. Ford Motor Co., ruled, for example, that "courts of equity will not interfere in the management of the directors unless it is clearly made to appear that they are guilty of fraud or misappropriation of the corporate funds, or refuse to declare a dividend when the corporation has a surplus of net profits which it can, without detriment to its business, divide among its stockholders, and when a refusal to do so would amount to such an abuse of discretion as would constitute a fraud, or breach of that good faith which they are bound to exercise towards the stockholders."^[11]

See also

• Company
• Corporate law
• US corporate law
• UK company law
• German company law

• In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996)

Notes

1. ^ Gimbel v. Signal Cos., 316 A.2d 599, 608 (Del. Ch. 1974)
2. ^ ^{a b} Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)
3. ^ Aronson v. Lewis, 473 A.2d 805, 812 (1984); Kaplan v. Centex Corp., Del. Ch., 284 A.2d 119, 124 (1971); Robinson v. Pittsburgh Oil Refinery Corp., Del. Ch., 14 Del. Ch. 193, 126 A. 46 (1926)
4. ^ See Aronson v. Lewis, 473 A.2d 805, 812 (1984); Puma v. Marriott, Del. Ch., 283 A.2d 693, 695 (1971).
5. ^ Black's Law Dictionary. 2001.
6. ^ Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971)
7. ^ Smith v. Van Gorkom, 488 A.2d 858 (1985), at 872-73. The judgment notes "A director's duty to exercise an informed business judgment is in the nature of a duty of care, as distinguished from a duty of loyalty."
8. ^ See Guth v. Loft, 5 A.2d 503 (1939), at 510.
9. ^ ^{a b} Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).
10. ^ See Gagliardi v. TriFoods Int’l Inc., 683 A.2d 1049, 1052 (Del. Ch. 1996) (setting out rationale for the rule).
11. ^ Dodge v. Ford Motor Co., 204 Mich. 459, 170 N.W. 668 (1919).

External links

• Companies House in the UK

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