Business Judgment Rule


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Business Judgment Rule

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."

Subsequently, the business judgment rule was applied to directors' actions when corporations were 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 20-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 when 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 than 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.

Further readings

Balotti, R. Franklin, and Jesse A. Finkelstein. 1988. The Delaware Law of Corporations and Business Organizations. Englewood Cliffs, N.J.: Prentice-Hall.

Baynes, Leonard M. 2003. "Racial Stereotypes, Broadcast Corporations, and the Business Judgment Rule." University of Richmond Law Review 37 (March): 819–99.

Branson, Douglas M. 2002. "The Rule That Isn't a Rule—The Business Judgment Rule." Valparaiso University Law Review 36 (summer): 631–54.

Brown, Meredith M., and William D. Regner. 2003. "What's Happening to the Business Judgment Rule?" Insights: The Corporate & Securities Law Advisor 17 (August).

Clark, Frank, G. W. Dean, and K. G. Oliver. 1997. Corporate Collapse: Regulatory, Accounting, and Ethical Failure. New York: Cambridge Univ. Press.

Gervurtz. 1994. "The Business Judgment Rule: Meaningless Verbiage or Misguided Notion?" Southern California Law Review 67.

Velasquez, Manuel G. 1997. Business Ethics: Concepts and Cases. Paramus, N.J.: Prentice-Hall.

Cross-references

Immunity; Negligence.

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