If you are an officer or director accused of making a bad decision, the “business judgment rule” is an important defense to understand.
In general, directors and officers of a corporation (including nonprofit organizations) owe the corporation a duty of care. This “duty of care” means you must act in a manner a reasonably prudent person would in a similar position.
However, courts have recognized a problem: it’s easy to criticize someone’s judgment after the fact. That is, with the benefit of hindsight, it’s easy to point fingers and say “that isn’t what a reasonably prudent person would do.” With this in mind, courts have adopted the business judgment rule.
The American Law Institute provided a nice summary of the business judgment rule:
“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.”
In other words, as long as a director or officer fulfills these requirements, they are protected by the business judgment rule and cannot be liable for breaching their “duty of care” to the corporation.
One notable case illustrating the business judgment rule involved the board of the Walt Disney Company. See In re The Walt Disney Co. Derivative Litigation, 906 A.2d 27 (Del. June 8, 2006).
Michael Eisner, chairman of the Board, negotiated the terms of an offer to hire Michael Ovitz as CEO. Then the Board approved the offer with very little discussion. Soon afterwards, Ovitz became a problem and was fired without cause after only 12 months. Inside the offer to hire Ovitz were terms giving Ovitz a $140 million “golden parachute.” This meant Ovitz was entitled to receive $140 million after being fired.
Disney shareholders were shocked and outraged. If the board had done their job, wouldn’t the board have spent more time considering such a huge decision? In hindsight, the board’s decision seemed reckless and capricious. How could the board approve such a huge contract with so little deliberation?
Thus, Disney shareholders sued the board members individually, claiming the board members breached their duties of care and loyalty to the company by approving such an expensive deal with so little examination.
The Supreme Court of Delaware held that the board members were not personally liable for harm to the company from their poor decision because Disney board members were protected by the business judgment rule. While no deliberation would be a violation of the duty of care, the court determined the Disney board had enough deliberation to satisfy the legal requirements.
To protect yourself from being accused of making bad decisions, here are a few tips:
The first requirement of the business judgment rule is that you are “not interested in the subject of his business judgment.” This means, for example, you cannot be personally involved in the transaction you are deciding. This includes those with fiduciary duties, contractual duties, or family affiliation (e.g. family members, business associates, business partners, employees, co-workers). If you have one of these conflicts of interest, consider excusing yourself from the vote/decision.
The second requirement of the business judgment rule is that you are “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.” This means you should spend at least some time examining the information required to make an informed decision. You don’t have to examine source information; you are entitled to rely on information and advice presented to you by leaders in your company.
The third requirement of the business judgment rule is that a director or officer “rationally believes that the business judgment is in the best interests of the corporation.” This means you need at least some logical reason (even if it is eventually determined to be poor logic) that the decision you are making is in the best interests of the corporation.
By fulfilling these requirements, you are establishing a solid basis for protection under the business judgment rule.
If you’re an officer or you serve on a board as a director in a company, you might be wondering about fiduciary duties, how they work, and what is the relevance of the business judgment rule.
My name is Aaron Hall. I’m an attorney in Minneapolis, Minnesota, and I’ll be addressing common questions I receive on these topics. So first off, what are fiduciary duties? Quite simply, when you accept to serve as an officer, director, or frankly anyone within an organization, you have fiduciary duties to that organization. That includes nonprofit organizations, C corporations, S corporations, LLCs, partnerships.
Now what are fiduciary duties? It’s the obligations or responsibilities that you owe the organization. They’re the kind of thing that are so simple and obvious that they apply to every organization. You have a duty of loyalty. In other words, you can’t go out and conspire against the organization. You have a duty of honesty, full honesty. You have a duty of care. In other words, using reasonable care and diligence in fulfilling your duties.
Let’s talk through those a little bit more. Duty of loyalty. This means you can’t use your knowledge in the organization against the organization. You can’t go compete with the organization. If you hear about a great opportunity, you need to offer it to the organization first if it relates to what the organization does. So that’s the duty of loyalty.
The duty of honesty means anything that is material to the organization, anything that is significant, anything that’s important for the organization to know, you need to tell the organization. If you have a conflict of interest, you need to disclose that. If you hear about something that would affect the organization, you need to let the organization know that. That’s what that duty of honesty is. It’s full honesty. It’s not just honesty if you’re asked. It’s actually being proactive and making that information available to the organization. And again, it’s not all information that you’ve ever accessed. It’s that information that is important to the organization and the operations of the organization.
And then finally, the duty of care. The duty of care simply means you need to be careful. You need to not be negligent. You need to fulfill your obligations in the way that an ordinary prudent person would in your particular role. Now, here’s the problem that comes up and this is where the business judgment rule arises. Let’s say you did the best you could, but in making a decision for the organization, it was a bad decision. It’s very easy to be a Monday morning quarterback where you sit and say, “Oh, the coach shouldn’t have done that play yesterday. That was a stupid play.” Well, it’s easy to say that now because we’ve seen how the play transpired. We have the benefit of hindsight.
Well, that’s the problem with the duty of care. At the time, you’re doing the best you can, but what happens if the next day or a year later, the decision you made turns out to have been a bad decision? Well, in that case, the business judgment rule comes into play. Courts have recognized that it’s really easy to sit and criticize decisions that officers or directors have made after you see the negative consequences of those decisions. And it’d be easy to say, “Hey, they breached their duty of care because a reasonable person wouldn’t have made that decision. We now know based on the consequence that arose.”
Well that’s not fair. So the business judgment rule arose and the business judgment rule simply says, “As long as the officer or director had no conflict of interest, as long as the person making the decision was truly trying to do what was in the best interests of the organization, it doesn’t matter that the outcome was bad.”
So the court’s going to look at a couple things here. Did the person making the decision have a conflict of interest? “Were they disinterested” is the legal term. And then second, did the person making the decision at least conduct some due diligence before making that decision? In other words, it wasn’t grossly negligent. They didn’t just say, “I don’t want to hear the information. I don’t want to weigh any of the factors. We’re just going to go do this.” That’s reckless. That’s grossly negligent. As long as they haven’t done that, then the person making the decision gets the benefit of the business judgment rule and even though the decision seems to be bad in hindsight, the business judgment doctrine says they are still deemed to have fulfilled their duty of care.
This ties in to another concept called good faith. Business owners, directors, officers are always required to have good faith in what they’re doing. That duty of good faith is also imposed by law on all parties who enter into contracts in Minnesota. So the duty of good faith really means, “Hey, we had good intentions here. There was no intent to defraud. There was no conflict of interest. The people were genuinely trying to do what was the right thing here.”
Admittedly it’s vague. Who decides if something was good faith? Well a judge will decide, not you. And the judge will be looking at what would a reasonable person have done based on the similar circumstances and similar situation? So there you have it. That’s a summary of the fiduciary duties that officers, directors, and business owners and employees owe to the organization. The duty of loyalty, the duty of honesty, the duty of care, which has an important exception with a business judgment rule, and the duty of good faith.
I’m Aaron Hall, an attorney in Minnesota. In the description below, there’s a link for additional information and you’re welcome to contact me if you have questions.