The business judgment rule is the most prominent and important standard of judicial review under corporate law. The rule protects the decisions of a corporate board of directors from a fairness opinion review unless a well pleaded complaint provides sufficient evidence that the Board has breached its fiduciary duties or that the decision making process is tainted.
In effect, the business judgment rule favors of the board of directors of a corporation. This is accomplished by freeing its members from possible liability for business decisions that result in a loss 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.”
The rule exists so that a board will not suffer legal action simply from a bad decision. In Sinclair Oil v’s Levien, the Delaware Supreme Court stated, a court
“will not substitute its own notions of what is or is not sound business judgment … (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.”
The Importance of the Business Judgement Rule
The constant wrangling between shareholders and business leaders suggests that in the daily operation of a business, as well as its long-term strategy, controversial and unpopular decisions will be made. This may involve taking a certain amount of business risk which may not be completely understood by all the stakeholders. Although all business decisions contain some level of risk, it is generally accepted that higher profits require taking greater risks.
The principle underlying the business judgment rule is that the board of directors should be allowed to make such decisions without fear of prosecution by shareholders who might object. The rule assumes that it is unreasonable to expect managers to make optimal decisions all the time. As long as a court believes that directors are acting rationally and in good faith, and not with a lack of independence or interestedness, it will take no action against them.
Although this may limit shareholder recourse, Bernard S. Sharfman writes in the The Importance of the Business Judgment Rule, that without the rule,
First, without the Rule, the raw power of equity, as made clear in Bodell I, could conceivably require all challenged Board decisions to undergo an entire fairness review. In the face of this power, the issue for the courts is to determine how the interests of stockholders are to be balanced against protecting the Board’s statutory authority to run the company without the fear of constantly facing potential liability for honest mistakes of judgment, the first policy driver underlying the Rule. This requires equity to be restrained in order to have balance with Board authority as provided by statutory law. The courts do this by applying the Rule as a tool to determine when a Board decision should stand without further review or when an entire fairness review is required and the full force of equity is to be applied. This is the most important function of the Rule, not the preclusion of duty of care claims.
Challenges Under the Business Judgement Rule
Despite the above, there will be instances in where director decisions end up in the courts. A director who sells a company asset to a family member for an obviously low price for example would be an example of self dealing and the rule would not offer protection.
In mergers and acquisitions, the business judgment rule is concerned with whether or not the directors have discharged their fiduciary duty and obtained the best deal for the stockholders. This may not always be the highest or superior offer, but the board should be able to demonstrate alternative offers were sought or the highest bid attained from the winning acquirer. These details should be made available in company filings with the SEC.
