How the ‘Business Judgment Rule’ Protects Directors and Officers

If you are an officer or director accused of making a bad decision, the “business judgment rule” is an important defense to understand.

Directors and Officers Owe a Duty of Care

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 Business Judgment Rule Protects Directors and Officers

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.

The Disney Example

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.

You can read the entire opinion here. If you want to read an analysis of the case, here is a good blog article published by the ABA: Disney directors survive attack on Magic Kingdom.

Practical Tip for Directors and Officers

To protect yourself from being accused of making bad decisions, here are a few tips:

Disinterested

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.

Informed

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.

Best Interests of the Corporation

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.