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 poten-
tial hostile takeovers by other businesses. To help
directors and officers meet these challenges
without fear of liability, courts have given sub-
stantial 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. Pennsyl-
vania 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 deal-
ing with only one investment house and by gen-
erally 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.â€
Subsequently, the business judgment rule
was applied to directors’ actions when corpora-
tions were faced with a hostile takeover. In Uno-
cal 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 Petro-
leum Company made an offer that would have
made it the majority shareholder in Unocal Cor-
poration.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 per-
cent of stock held by Mesa.Mesa filed suit, alleg-
ing 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 share-
holders. The court stated that the Unocal direc-
tors 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 direc-
tors of a corporation failed to exercise informed
business judgment and instead acted in a grossly
negligent manner by agreeing to sell the com-
pany 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 direc-
tors 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 fail-
ing 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 sharehold-
ers. 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 deter-
mined 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 pro-
tection 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.
