How Can You Overcome the Business Judgment Rule?

By Gerald P. Burleson, Member of the California Bar, and

Amanda Purcell, University of San Diego Law School

© 2017 by Gerald P. Burleson, all rights reserved

Broadly speaking, the business judgment rule protects business decisions by corporate directors from judicial review. Specifically, it creates a presumption that when corporate directors make business decisions, they do so in good faith, on an informed basis, and with the best interests of the company in mind.[1] When the business judgment rule applies, courts will take a “hands off” approach and will not intervene with a corporation’s sound business decision. Importantly, the business judgment rule is the default standard of review in Delaware.[2] However, under certain circumstances the business judgment rule can be overcome and in some situations it does not apply at all. When this is the case, courts will review the business decision or the decision making process.

First, under the business judgment rule, the party challenging the corporate decision has the burden of rebutting the presumption. A shareholder-plaintiff can do this by proving that the directors breached their fiduciary duties in making the decision, i.e., they acted in bad faith or breached duties of care or loyalty.[3] In addition, a shareholder-plaintiff can prove that the directors committed waste. Once the presumption is successfully rebutted, the burden shifts to the defendant directors to prove entire fairness, which is that the transaction was “fair to the corporation and its shareholders.”[4]

Conflict of Interest:

The business judgment rule rests on the crucial notion that when making business decisions, corporate directors are independent and disinterested. Accordingly, a shareholder can overcome the business judgment rule presumption if the shareholder provides evidence of a conflict of interest in a corporate transaction. In doing so, the shareholder must prove that in making a business decision, the majority of the board of directors were interested in the transaction. Interested directors are those who “appear on both sides of a transaction” or “derive personal financial benefit from it in the sense of self-dealing, as opposed to a benefit which devolves upon the corporation or all the stockholders generally.”[5] Even if a shareholder can prove that an interested transaction occurred, the shareholder must overcome three exceptions enumerated under the Delaware General Corporation Law (“DGCL”).[6] DGCL section 144, subdivision (a) essentially states that even if one or more directors are interested, the transaction is not automatically voided if three circumstances occur:  (1) if the majority of disinterested directors approve the transaction through affirmative votes and the board of directors or committee knows the material facts relating to the conflict of interest; (2) if the shareholders, in good faith and with knowledge of the material facts relating to the conflict of interest, approve the transaction through votes; or (3) if the transaction is fair to the corporation at the time it was approved.  If any of these three scenarios apply, then the business judgment rule also applies.

Shareholder-plaintiffs are also able to overcome the business judgment rule in the context of special litigation committees. For example, in In re Oracle Corp. Deriv. Litig., 824 A.2d 917, 942 (Del. Ch. 2003), the court found that the financial and collegial connections between members of a special litigation committee and director defendants, created a reasonable doubt about the committee members’ independence.  The court focused on the committee members’ ability to make impartial and objective decisions emphasizing that connections between a member of the committee and a defendant involving their work and associations at the same university as well as potential donations would heighten the risk of bias.[7] The court concluded that the special litigation committee’s motion to dismiss the shareholder derivative action would be denied because the committee’s partiality required a merits inquiry.[8]

 

Uninformed Decision:

Under the business judgment rule, directors and stockholders must be properly informed when making business decisions. This means all material information that is reasonably available should be considered or looked at before reaching a decision.[9] The presumption of informed decision-making is based on the duty of care, and if directors are grossly negligent by failing to inform themselves, they will not be protected under the business judgement rule. In Smith v. Van Gorkom, 488 A.2d 858, 893 (Del. 1985), the court found that the directors breached their duty because the decision to sell their company was uninformed. The court noted that the directors made their decision on the transaction before gathering information on the intrinsic value of the company, without documentation, after a 20-minute presentation, and the presentation did not include a written summary of the terms of the merger.[10] Similarly, if a shareholder vote is uninformed or coerced, the business judgment rule will not attach.[11]

 

Fraud, Illegal Conduct, Self-Dealing:

If a shareholder-plaintiff in a derivative action can establish fraud, illegal conduct, or self-dealing by the directors, the decision will be reviewed and will not be protected by the business judgment rule.  However, the business judgment rule insulates directors from negligence liability and a court will not review decisions where the shareholder-plaintiff claims negligence or general mismanagement.[12]

 

Waste:

If a shareholder-plaintiff can prove that the board of directors committed waste, the business judgment rule will be overcome.  This occurs when the board of directors uses company assets in a way that no reasonable business person of ordinary, sound business judgment would (which is admittedly rare). Directors, however, can widely make decisions on executive compensation, which is generally subject to the business judgment rule.[13]

 

Bad Faith:

Directors also breach a fiduciary duty when they act in bad faith.  This occurs when they act with an intent that does not incorporate the best interest of the corporation, they act with intentional dereliction of duty, or they act with a conscious disregard of one’s responsibilities.[14]  In other words, it is an action “so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith.”[15]

 

Final Notes

The business judgment rule only applies to business decisions by the board: it does not protect decisions by officers. Under DGCL section 102, subdivision (b)(7) the statute expounds that directors can be exculpated from the duty of care through a provision in the corporation’s articles of incorporation, but officers cannot be. Additionally, directors have a duty of care and a duty to have a general understanding and knowledge of a corporation’s business.  The business judgement rule has no application when directors have failed to make a decision or exercise business judgment. This is exemplified in the case Francis v. United Jersey Bank, 432 A.2d 814, 829 (N.J. 1981), where the court held that a corporate director can be held individually liable when the director is not familiar with the business. In that case, the director did not fulfil her director obligations including reading the financial statements that would have disclosed company misappropriation.

Notably, a shareholder must show more than “imprudence or mistaken judgment” in order for a business judgement decision to be judicially rescindable.[16]

In sum, although the business judgment rule can be a formidable obstacle for shareholder-plaintiffs, there are multiple circumstances were the presumption can be overcome and business decisions should be reviewed on the merits.

[1] Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)

[2] In re Trados Inc. S’holder Litig., 73 A.3d 17, 43 (Del. Ch. 2013)

[3] In re Walt Disney Co. Deriv. Litig. 906 A.2d 27, 52 (Del. 2006)

[4] Id. at 57.

[5] Aronson, supra, 473 A.2d at p. 812

[6] Section 144, subdivision (a), provides in full:  “(a) No contract or transaction between a corporation and 1 or more of its directors or officers, or between a corporation and any other corporation, partnership, association, or other organization in which 1 or more of its directors or officers, are directors or officers, or have a financial interest, shall be void or voidable solely for this reason, or solely because the director or officer is present at or participates in the meeting of the board or committee which authorizes the contract or transaction, or solely because any such director’s or officer’s votes are counted for such purpose, if:  (1) The material facts as to the director’s or officer’s relationship or interest and as to the contract or transaction are disclosed or are known to the board of directors or the committee, and the board or committee in good faith authorizes the contract or transaction by the affirmative votes of a majority of the disinterested directors, even though the disinterested directors be less than a quorum; or (2) The material facts as to the director’s or officer’s relationship or interest and as to the contract or transaction are disclosed or are known to the stockholders entitled to vote thereon, and the contract or transaction is specifically approved in good faith by vote of the stockholders; or (3) The contract or transaction is fair as to the corporation as of the time it is authorized, approved or ratified, by the board of directors, a committee or the stockholders.

[7] Id. at p. 942-947.

[8] Id. at p. 948.

[9] Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985)

[10] Id. at p. 874.

[11] See Singh v. Attenborough, 137 A.3d 151 (Del. 2016) [“a fully informed, uncoerced vote of the disinterested stockholders invoked the business judgment rule standard of review.”]

[12] See Shlensky v. Wrigley, 95 Ill.App.2d 173, 174-183 (1968)

[13] 8 Del.C. § 122(5)

[14] In re Walt Disney Co. Deriv. Litig., supra, 906 A.2d at p. 67.

[15] Brinckerhoff v. Enbridge Energy Co., Inc., 67 A.3d 369, 373 (Del.2013)

[16] Kamin v. American Exp. Co., 86 Misc.2d 806, 813 (N.Y. 1976)

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