What is the Business Judgment Rule and Why Should a Shareholder Care About it?

By Gerald P. (“Jerry”) Burleson

© 2014 by Gerald P. Burleson, all rights reserved

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The business judgment rule is a legal principle of fundamental importance in the area of corporate governance. It was developed at common law, which means it was created by judges. There are two components of the business judgment rule which I will briefly discuss in this blog article.

In its broadest sense, the business judgment rule is a policy of respect by the courts for the business judgment of corporate directors in exercising their discretion in making corporate decisions. In other words, the courts take a “hands off” approach to the business judgment of corporate directors in their making of decisions that affect the corporation based on the assumption that the shareholders entrusted the directors with the management of the corporation, and they are better equipped than the courts to make a determination of whether a particular proposed action or transaction is in the best interests of the corporation. The business judgment rule creates a presumption that decisions by the directors are based on sound business judgment, and the rule prohibits courts from interfering with the directors’ business decisions made in good faith and where there is no conflict of interest. Berg & Berg Enterprises, LLC v. Boyle (“Berg”) (2009) 178 Cal.App.4th 1020, 1045.

There is another component of the business judgment rule which insulates directors from liability for their corporate decisions made in compliance with the requirements of the rule. In California, this director immunization from liability component of the business judgment rule has been codified in Corporations Code section 309, which says that a director “. . . must serve in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances.” Berg at 1037, 1045; Corporations Code, §309, subd. (a). Another part of that same statute says, in substance, that if a director acts in accordance with the requirements set forth in §309, the director shall have no liability based upon any alleged failure to discharge his or her obligations as a director. Corporations Code, §309, subd. (c).

From the viewpoint of a shareholder who is dissatisfied with action taken by the corporation’s board of directors, there are several implications from the business judgment rule. First, one should not assume that a court will readily set aside action taken by the board where there is any rational business purpose that supports it, absent facts showing director bad faith or conflict of interest. Second, the business judgment rule is likely to be one of the barriers that must be overcome by a shareholder pursuing a breach of fiduciary duty claim against one or more directors on the board. The circumstances under which a business judgment rule defense can be overcome will be the topic of another blog article.

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