The Business Judgement Rule and the Fiduciary Duty of Care




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The Business Judgment Rule

            The business judgment rule is an important caveat to the corporate duty of care owed by officers and directors to their companies.

The duty of care requires directors and officers to act in as competent a manner as would reasonably prudent people in their positions.[1] Officers and directors must make decisions that they believe, in good faith, to be in the best interests of their companies and must make decisions after appropriate research and due diligence inquiries. The decisions must be the products of appropriate care and thought.

Officer and directors who fail to uphold their duties of care can be subject to shareholder lawsuits, including shareholder derivative actions, for any damages caused by these failures. These lawsuits, which can subject officers and directors to heavy monetary liability, are very powerful tools to penalize derelict directors. This is evident from high-profile shareholder derivative suits that have been brought against directors of many major corporations, including Apple, Citigroup, Walt Disney, and Enron, wherein shareholders have successfully challenged activities of boards of directors.[2]

The business judgment rule is a standard of judicial review of corporate director and officer conduct.[3] As corporate responsibilities are typically governed by state law, there is no one uniform definition of the “business judgment rule” that applies throughout the country.[4] In fact, it’s inconsistent and uncertain approach across jurisdictions has led to its being called “the most enigmatic doctrine in corporate law.”[5]  

The rule protects officers and directors from liability where they have made decisions in good faith and using appropriate procedures, even if those decisions turn out to be poor or unwise. Corporate officials eligible for protection under the business judgment rule are not liable for breaching duties of care merely because they have made mistakes.

However, to be eligible for this protection, the corporate officials must have met certain standards of conduct. These are illustrated in the American Law Institute’s formulation of model business judgement rule language, crafted to help states draft laws on corporate governance.[6] The ALI language provides:

“(c) A director or officer who makes a business judgment in good faith fulfills the [duty of care] if the director or officer:

(1) is not interested in the subject of his business judgment;

(2) is informed with respect to the subject of the business judgment to the extent the director or officer reasonably believes to be appropriate under the circumstances; and
(3) rationally believes that the business judgment is in the best interests of the corporation.”[7]

Many states, such as Delaware and Georgia, presume that the business judgment rule always applies to the actions of directors and officers: “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.”[8] Assuming those conditions are met, corporate officials are not liable for adverse consequences of decisions that turn out to be inadvisable.

Stone v. Ritter, a 2006 case from Delaware, illustrates a classic application of the rule. In that case, the federal government fined AmSouth Bank over $40 million for failures to file reports that were required by federal anti-money laundering laws. The shareholders of AmSouth Bank sued the bank’s directors, alleging that they had breached their duty of care by failing to require the company to implement monitoring and reporting systems, which could have prevented the violations from occurring.[9]

The court held that the business judgment rule presumption applied, and thus shielded the directors from liability for their decision not to implement the monitoring system demanded by the shareholders. The court thus dismissed the plaintiffs’ complaint. The court reasoned that for the liability protection of the business judgment rule to be overcome, the shareholders must demonstrate “a sustained or systematic failure of the board to exercise oversight” or “establish the lack of good faith.”[10]

The facts demonstrated that the directors did exercise oversight in good faith. The directors had enacted relevant procedures and policies on how to adhere to anti-money laundering laws. Additionally, the defendant directors had solicited, received and relied on periodic reports from the compliance department and had explicitly tasked individual employees with monitoring federal regulation enactments. Though the corporation broke laws and the corporation’s system had failed to prevent or detect these violations, the directors weren’t at fault, as they had done as much as was reasonable to protect their company. That their efforts were unsuccessful is not an inherent indication that they violated their duties of care.

The business judgment rule protects the business decisions of corporate directors and officers who are sued by shareholders for claims of a breach of the duty of care.[11] If their actions are supported by appropriate due diligence, are in good faith and do not create conflicts of interest, they will be protected from liability even if their decisions cause damage to their companies.



Footnotes

[2] Ann Scarlett, “A Better Approach for Balancing Authority and Accountability in Shareholder Derivative Litigation”, 57 Kan. L. Rev. 39, (2008).

[3] Lindsay Llewellyn, “Breaking Down the Business-Judgment Rule”, American Bar Association Commercial & Business Litigation Section, (2013).

[4] Douglas Branson, “The Indiana Supreme Court Lecture: The Rule That Isn't a Rule - The Business Judgment Rule, 36 Val. U.L. Rev. 631, (2002).

[5] D. Gordon Smith, “The Modern Business Judgment Rule”, The CLS Blue Sky Blog, (2015).

[6] Rosenfield v. Metals Selling Corp., 643 A.2d 1253, 1261 (Conn. 1994).

[7] ALI Corp. Governance Project, Section 4.01 (c).

[8] Aronson v. Lewis, 473 A.2d 805, 1984 Del. LEXIS 305 (Del. Mar. 1, 1984).

[9] Stone v. Ritter, 911 A.2d 362, 2006 Del. LEXIS 597 (Del. Nov. 6, 2006).

[10] Id.

[11] Fred Triem, “Judicial Schizophrenia in Corporate Law: Confusing the Standard of Care with the Business Judgment Rule”, 24 Alaska L. Rev 23, (2007).