What is the Business Judgment Rule?

The Business Judgment Rule is a legal rule in business law. It helps protect company directors and executives when they make business choices for the company.

As long as the directors and executives make careful decisions based on the right information, the Business Judgment Rule says courts should not question if the decision was right or wrong. Instead, courts only look at whether the directors gathered the facts and information they needed to make a good choice. This is called fulfilling their “duty of care”.

Why the Rule Exists

The rule exists because judges and courts are not business experts. The directors and executives know the company best. They are in the best position to make smart choices to help the company succeed.

If directors always worried that a court would say their decisions were wrong, they might be afraid to take risks. Businesses need to take some risks to grow and be profitable. The Business Judgment Rule gives directors the freedom to make bold moves.

When the Rule Applies

But the rule does not protect directors in all situations. It only applies when:

• Directors make a decision for the company (not for themselves)
• Directors make a thoughtful choice (not a reckless one)
• Directors have no conflicts of interest with the decision
• Directors have the basic facts and details they need

If directors meet these standards, then courts will not second-guess if the decision was the right one to make. Directors are protected even if a choice turns out badly for the company.

Duty of Care

The most important part of the Business Judgment Rule is the “duty of care”. This means directors must be careful and thorough when making a choice for the company. They need to study the important facts and consider the major risks.

The directors do not have to be perfect. But they have to make a decent effort to be informed before deciding. If directors are sloppy or careless, the Business Judgment Rule will not protect them.

Getting Informed

There are many ways directors can fulfill their duty of care. They can:

• Attend board meetings regularly
• Read the relevant reports and financials
• Ask questions of managers and experts
• Fully discuss the pros and cons of a choice
• Consider reasonable alternatives

Doing research and thinking through the decision shows the directors are being careful. This helps them use their judgment to pick what is best for the company and its shareholders.

When Courts Get Involved

In most cases, courts stay out of business decisions. Judges know they are not business experts. The Business Judgment Rule is a high bar to get over.

But the rule is not a blank check. Courts will step in if directors are way out of line. Here are some situations where directors can get in trouble:

Fraud or Illegal Choices

Directors cannot break the law or commit fraud. The Business Judgment Rule never protects criminal conduct. Directors who lie, cheat, or steal from the company will be liable.

Conflicts of Interest

Directors must make choices that are best for the company, not for themselves. If a director has a personal interest that is different from the company’s interest, then there is a “conflict of interest”.

When there is a conflict of interest, courts will look very closely at the director’s choice. The director must prove the decision was fair and reasonable for the company. If not, the court can overrule it.

Gross Negligence

Directors are allowed to make mistakes. Not every decision will be perfect. The Business Judgment Rule protects directors who try their best and still get a bad result.

But the rule does not protect directors who are sloppy beyond belief. “Gross negligence” means the directors were so careless it was almost the same as fraud. If directors act with gross negligence, courts can hold them liable for the harm to the company.

Important Court Cases

Over the years, major court cases have shaped our understanding of the Business Judgment Rule. Here are some key examples:

Smith v. Van Gorkom (Delaware 1985)

In this case, a board of directors approved selling the company after a very short meeting with no advance notice. The court said this violated the duty of care. The directors needed more information to make such a big decision. This case showed that directors must inform themselves before acting.

In re Caremark (Delaware 1996)

This case involved illegal employee conduct. The court said directors have a duty to make sure there is a system to catch employee wrongdoing. If the directors utterly fail to have any reporting system, they breach their duty of care. This case expanded a board’s oversight duties.

Brehm v. Eisner (Delaware 2000)

The Disney Company hired a top executive who only lasted a short time before being fired with a big severance. Shareholders sued, saying the board should not have hired him. But the court stood by the Business Judgment Rule. Since the board did research and discussed the hire thoroughly, the court would not second-guess the decision.