The Business Judgement Rule

The last Spanish Corporate Governance reform introduced the Business Judgement Rule (BJR) concept, stemming basically from the US courts in Delaware.

We will make an effort to give a broad and modern vision on the BJR in this post, given its prevalence in modern Corporate law or practice. In this effort we will primarily follow D. Gordon Smith`s article on “The Modern Business Judgement Rule”, (1).

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An initial BJR formulation by courts is recognized in 1927 Delaware court´s decision in the Bodell vs. General Gas & Electric Corporation case. A first approach would outline the BJR protects directors from liabilities stemming from “honest mistakes”either as to law or fact, somehow recognizing the human fallability, but also the fact that it reduces legal costs as directors find it difficult to please every shareholder, as S. Samuel Arsht stated in 1979 (2).

Origination of the BJR.

Arsht refers to the 1829 Louisiana Supreme Court decision in Percy v. Millaudon, (a defalcation case), to the 1847 Alabama Supreme Court decision on Godbold v. Branch Bank, (a case of incorrect employment and compensation payment), and to the 1850 Hodges v. New England Screw Corp. case, (a decision against the company charter). These cases give shape to the BJR in several aspects:

  • They clearly express the logic and the limits of the BJR;
  • They emphasize the reasonable diligence and care directors must observe. That is, the BJR does not preclude courts from examining the methodologies and procedures followed in the decision-making process.

The essence of the BJR.

Following Smith, we can say the BJR supposes several assumptions:

  1. Directors have made a decision. Lack of action or inattention is not protected.
  2. Directors were careful, that is they inquired into, were informed about and deliberated on the decision.
  3. They were loyal, that is disinterested.
  4. They were unbiased and motivated by the welfare of the corporation, (acted in good faith).

Courts have often refered to irrationality (although if four assumptions above are present irrationality is difficult to find), and to “waste” or “gift”, although both can be driven to “bad faith”. Courts have also sometimes introduced some confusion, (in the sense that it is perceived as a shield against liability), when linking the BJR to “gross and palpable overreaching”, “fraud” or “self-dealing”, (see Arsht). Sometimes a court decision based in one of the four assumptions is perceived and exemplified as a theory of the BJR, which clearly reduces and curtails its scope, as Bernard S. Sharfman thinks regarding the Aronson v. Lewis case, which focused on assumption 2 above. (3).

As Smith tells us, the BJR has recently evolved and expanded. In cases were directors had an economic interest, or when the independence of directors can be said to be undermined by a controlling stockholder, the courts have found a way back to the BJR. Protection for directors is granted by courts when the procedural infirmities are mitigated. The mitigating tool can be a special committee, shareholder approval, or a partial substantive review by the court. The border between judicial review and judicial deference is so established in a moving boundary, as courts are still introducing variations, particularly regarding merger and acquisitions, where cases have been rather abundant lately.

The essence of the BJR. Other aspects. 

  1. The BJR as a presumption that directors act as described above, so that any plaintiff needs to at least prima facie present a case where directors can be said to have acted against the above procedures.
  2. The BJR as a Standard of Care. As sometimes refered to by courts, the BJR rule does not apply in the presence of gross negligence, (which has been argued to defend that the BJR so degrades the Standard of Care).
  3. The BJR as (procedural) abstention doctrine. As Prof. Bainbridge states, the BJR effect is no court further action follows when the conditions are met. (4)
  4. The BJR as a substantive Rule of Law. In the sense that certain decisions deserve protection when the BJR conditions are met.

The BJR in practice, (see (2))

Arsht reviews each element of the BJR in the context of courts decisions, as follows:

1.- Personal interest limitation: duty of loyalty.

In 1939`s Guth v. Loft the court states that “directors and officers can`t use their position of trust and confidence to further their private interests”. An inherited rule forces them to act in favor of the corporation, refraining from doing something that could harm its interests or deprive it of a profit or advantage. There should not be a conflict between duty and self-interest. What underlies is that personal interest may affect business judgement, so that a director must prove the fairness of his decision in these cases. A personal interest exists when a director may receive a profit the company does not, or receive it other than on a pro rata basis with all other stockholders, as a result of a transaction. And courts need to assess the nature and degree of the interest to determine whether business judgement might have been affected.

2.- Exercise of Due Care.

The rule does not lower the standard of care required to directors, as shown in cases Percy v. Millaudon, Godbold v. Branch Bank, and Hodges v. New England Screw Co.. In Casey v. Woodruff it is clearly stated that directors are protected only when their decision was an informed one, as if they don´t seek any available facts regarding the decision, no business judgement can take place.

3.- Abuse of Discretion.

A decision must be the result of sound judgement, a judgement that cannot be defended in any rational basis does not deserve the BJR protection. This limit to the BJR is often present in merger or acquisition cases, in connection with price inadequacies allegations by shareholders. “Fraud” and liability do not only stem from dishonest behavior but also from absence of reasoned judgement regarding the price, (Allied Chemical & Dye Corp. v. Steel & Tube Co.).

Moreover, in Gimpel the court went even further: recognizing the board had discharged its duties in a sound judgement, it found that a set of facts that if proved could demonstrate the price was inadequate, and could lead to think directors had acted recklessly in this case.  In Thomas v. Kempner the relevant fact was the existence of an offer equal in everything to the one the board accepted, but at a higher price. In summary, the rule mandates an inquiry into the set of facts in a court assessment of a sound judgement.

4.- Lack of Good Faith.

Improper behavior may be driven by the will to remain in office, in case a decision is taken solely or primarily for this reason, although if remaining in office is incidental the BJR still applies. Lack of independence from a controlling shareholder may also damage the Good Faith presumption, as illegal conduct does, even ir adopted in the best interests of the corporation.

Smith refers particularly to the BJR in takeover cases, but we will leave that to a different post.

(1) Smith, D. Gordon, The Modern Business Judgment Rule (June 19, 2015). Research Handbook on Mergers and Acquisitions, Forthcoming ; BYU Law Research Paper Series No. 15-09. Available at SSRN: https://ssrn.com/abstract=2620536

(2) “The business judgement rule revisited”, by S. Samuel Arsht, can be downloaded here: http://scholarlycommons.law.hofstra.edu/cgi/viewcontent.cgi?article=1269&context=hlr

(3) Sharfman, Bernard S., The Importance of the Business Judgment Rule (January 5, 2017). Available at SSRN: https://ssrn.com/abstract=2888052

(4) Bainbridge, Stephen M., The Business Judgment Rule as Abstention Doctrine (July 29, 2003). UCLA, School of Law, Law and Econ. Research Paper No. 03-18. Available at SSRN: https://ssrn.com/abstract=429260 or http://dx.doi.org/10.2139/ssrn.429260

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  1. January 29, 2017 at 2:37 pm

    See the article below, where a comparison is established with Spanish implant of the BJR. No presumption, and in general an opinion that US BJR really makes it very difficult to make directors accountable and sued unless a decision relies on gross negligence, and even huge irrationality …
    http://derechomercantilespana.blogspot.com.es/2017/01/una-nota-sobre-la-business-judgment-rule.html

    Like

  2. January 31, 2017 at 9:12 pm

    In a recent brief post in his blog, a Spanish Corporate Law professor described the BJR implementation in a recent legal reform and compared it to the court doctrine in the US and mainly in the state of Delaware. (1)

    Article 226.1 of the Spanish Corporate Law describes the Duty of Care, in a sense that it requires from directors adopting a decision the main elements described in our previous post regarding the Delaware case, that is: (i) Good faith (ii) loyalty (iii) Care, that is a will to be informed and (iv) an adequate decision-making procedure.

    In Spain the relationship between directors and shareholders is considered a contractual one, so that directors must abide by their obligations and prove (in case of litigation) that the above requirements have been fulfilled, that is they need to keep all documents, acts, necessary comments in these acts, so as to be able to do it. There is no presumption that they have acted with enough care. In the Common law regime, (as Prof. Alfaro says), this presumption exists, as the relationship is not considered a contractual one. In this case, boards´documentary burden is lower, the costs imposed on shareholders willing to sue them are higher, and so directors are protected by a bigger wall.

    (1) http://derechomercantilespana.blogspot.com.es/2017/01/una-nota-sobre-la-business-judgment-rule.html

    Like

  1. February 26, 2017 at 7:25 pm
  2. March 26, 2017 at 2:47 pm

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