The Business Judgment Rule


See Also:


Terms:


Punitive Damages
Damages that go beyond compensation to the victim of a tort or other malfeasance and that are designed to punish the guilty party and to discourage the type of behavior that led to the action being brought. In situations where companies or directors have violated their fiduciary duties or otherwise acted criminally, punitive damages may be applied against them as well.

Best Efforts
“Best efforts” is merely another way of saying that when entering into a contract, both parties involved need to act to the full extent of their ability to ensure that the contract, as contemplated, is completed. Failing to make “best efforts” may be a violation of a party’s contractual duties.

Defining the Business Judgment Rule

Pinning down an exact definition of the Business Judgment Rule (“BJR”) is a difficult task. This is not because the phrase and its meaning are not daily part of the directors’ and officers’ management of the company. On the contrary, the BJR is something that corporate managers use every day. The reason why the rule is difficult to define precisely is that courts have used the term and applied it in so many different transactions that it is sometimes difficult to determine exactly how a court will apply it (or choose not to apply it) in a given situation.

Essentially, the principle of the BJR is as follows:

When a director or officer acts in good faith and with prudence in her determinations and actions, then there will be no liability implied by the court for resultant changes in the company’s circumstances or loss of value.

Tearing this definition apart is likewise a tricky task. However, given our previous work with directors and officers, there are no new terms to deal with. First, the director must act with good faith to have the protection of the business judgment rule. This means that the director must act for the benefit of the corporation as a whole, and not with his or her personal interests in mind. “Prudence” suggests that the director also needs to act upon reasonable assumptions and information and only reach a final course of action after sufficient investigation that evinces due diligence on the part of the director.

If all of the above conditions are met, the definition then tells us that the courts will, in essence, refuse to second-guess the actions of the director. See Shlensky v. Wrigley, 237 N.E.2d 776 (Ill. App. Ct. 1968). In other words, the court will refuse a request by shareholders, the government, or others to judge the directors harshly based on the outcome of their actions, rather than the circumstances that provoked the director’s action at the time of the decision.

This rule makes a great deal of practical sense for the operation of business in this country. The BJR recognizes that the conduct of business is an inherently risky endeavor. Additionally, the BJR recognizes that things can go wrong through no fault of the decision maker and that the best plans may often go awry.

Given this situation, the courts could have elected a path that held directors and officers responsible when their decisions cost the company money or other value, and imputed this loss to the director. However, if the courts had so decided, who would ever want to be a director? If you were a director acting on information that you reasonably believed to be accurate, and the company, despite your best efforts, lost money, and that loss was to be made up out of your bank account, how long would you continue to work as a director?

The reality that the courts have come to recognize is that it is not their place to judge the prudent director harshly if he ultimately loses money. Rather, the courts have come to realize that they need to protect the directors' ability to act on their reasonable beliefs in order to ensure that good and knowledgeable people manage companies and that they do so with the comfort that they will not need to reimburse the company when their goals are not met.

EXAMPLE: After hearing all of the evidence in a business case, the judge evaluated the facts and determined that while the company had lost a great deal of money in the transaction at issue, the directors had entered into the transaction after fully informing themselves as to the potential effects of the transaction, the likelihood of loss, and the financial and operational impacts it would have. Given the fact that the directors had performed a thorough due diligence analysis of the transaction, the judge decided that the directors were not liable for the resultant loss.

When does the BJR apply?

The BJR is a broad protection and covers the vast majority of decisions that a director will encounter on a daily basis. However, the Rule, like all such protections, does have its limits. Embedded within the rule are a series of requirements and caveats that ensure that the rule will not be abused by directors and officers who act for the benefit of themselves or others and not for the benefit of the company and its shareholders. Consider the following as a partial list of the prerequisites and subtext requirements of the rule, noting that the courts often expand this set when they feel, in their judgment, that a manager failed to act appropriately.

Prudence / Recklessness
As we have observed several times already, the courts are concerned that directors and officers adequately inform themselves about the nature and potential impact of their decisions, prior to putting those decisions into action. Thus, to enjoy the protection of the BJR, directors and officers need to first make a full investigation of the ramifications of their decisions. Directors who do their homework before acting take those actions can be certain in the knowledge that the courts will protect them come rain or shine. Directors who fail to study their decisions had better own a magic mirror capable of predicting the future, as losses attributable to their rash acts may result in liability outside the protection of the BJR.

In 1985, the Delaware Supreme Court took a major step toward limiting the BJR by showing a willingness to hold directors to be in breach of their fiduciary duties when a decision was made too hastily even when the company turned a profit on the transaction that was “hastily” performed. See Smith v. Van Gorkum, 488 A.2d 858 (Del. Sup. Ct. 1985). In Van Gorkum, the board of directors was forced to make a quick decision as to whether or not to sell a large amount of stock in the company at a moderate profit. Since there was no time to adequately research the deal, as the offer was to close within a couple of days of the time that the offer was made, the company agreed to the offer, without adequately researching the deal. The Delaware Supreme Court imposed liability on the directors, even though the transaction made a profit for the shareholders. The court reasoned that the company could have done better had it waited for a more thoroughly researched deal to present itself. The profit that the transaction netted for the shareholders did not justify the hasty decision, the Business Judgment Rule notwithstanding.


Fraud or Bad Faith
“Bad faith” action, which we might characterize as fraud or deceit on the part of the director, will also fall outside the protection of the BJR. If the director chooses to lie or to deliberately conceal information from the company or the rest of the board, any decisions made on the basis of those lies will ultimately result in civil and/or criminal liability on the part of the director committing the fraud. However, note that the BJR will generally protect the actions of directors and officers who acted on their beliefs that the information, which ultimately turned out to be a lie, was in fact the truth. In other words, the courts will still protect the director who reasonably believed the advice of an employee who lied. However, other directors who know of or have reason to know of the director’s fraud and still choose to act on the basis of that information will do so without the protection of the BJR.

EXAMPLE: Lloyd had discovered that Terrance, a fellow director, was embezzling funds from the company, illegally using the company car to his own ends, and generally acting in a manner deleterious to the firm. However, Terrance was an expert on stock issuances and had recently advised the firm that it should make a new issue of bonds to cover an upcoming transaction. While Lloyd knew that Terrance was generally untrustworthy, he believed that the advice Lloyd had given the board was financially sound. When the bond issuance ultimately tanked and the board was sued, Lloyd was not held personally liable because his beliefs about Terrance – as to the quality of his advice – were probably reasonable and protected by the Business Judgment Rule.


Breach of Loyalty 
In a previous section we discussed the duty of loyalty and the resultant liability of directors and officers who choose to compete with their company or usurp opportunities rightly belonging to the firm. In such a situation,   the resulting conflict of interest between the director’s duty to the company and his actions on behalf of himself eliminates any protection given by the Rule. In essence, what this means is that whenever a director acts on his own behalf at the expense of the corporation, the BJR will not protect his actions. See Northeast Harbor Golf Club, Inc. v. Harris, 661 A.2d 1146 (Maine Sup. Ct. 1995).

Exceeding the Scope of the BJR

In a general sense, there are only two possible outcomes when the scope of the BJR is exceeded. If a director acts in such a way that demonstrates a lack of prudence or potential fraud, and the company either does not suffer or actually benefits from the act, it is possible that no liability will result. Essentially, it is likely to be the case that if the director has acted rashly, perhaps even on a whim, and the company has made a profit from the otherwise inappropriate act, it is rare that a shareholder or government official will sue as no negative consequences have materialized.

There is, however, a more likely scenario. The reason why the courts require prudence and deliberate action is the fact that the more common result of rash action is a loss to (or, at least, a missed opportunity to gain) for the company and its shareholders. In the event of such a loss, and without the protection of the BJR, the director or officer can face a variety of consequences, any combination of which the court may see fit to exercise. Typically, the court will do what it can to roll back the effects of the transaction, unwinding it where possible to return to the pre-transaction status quo. Absent that possibility, the court will likely have the director removed and award damages in the amount of any lost value to the company and, in an egregious case, punitive damages as well. Finally, any violation of the BJR that is in violation of a statute or court order can subject the director to criminal liability and perhaps jail time for failing to act in compliance with the requirement of “best efforts” under the BJR.

EXAMPLE: Harry, a director of Green Co., had advised the company to engage in the development of a new type of television. However, Harry had no knowledge about the electronics industry, and as the board well knew, Harry had only been elected to the board because he was a superstar athlete and the company was in the business of producing athletic clothing. However, not wanting to offend him and lose his involvement in the company, the board chose to go along with his plan. When the TV business ultimately failed, Harry, along with the rest of the board, were held personally responsible for violating their fiduciary duties and exceeding the scope of the Business Judgment Rule.