The Law To Know

Business associations · United States · about 4 minutes

The business judgment rule

The building inspector

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In one breath

The business judgment rule presumes that directors act on an informed basis, in good faith and in the honest belief that their decisions serve the corporation. Courts will not second-guess the wisdom of a decision made that way, but the presumption falls away when directors are conflicted, act in bad faith or decide without being reasonably informed.

The picture

The building inspector

A building inspector checks whether a house was built properly: permits obtained, plans followed, no secret ties to the contractor. The inspector does not ask whether the owner should have chosen a red kitchen. Taste and strategy belong to the owner. As long as the process was clean, the result stands, even if the kitchen is ugly and the house loses value.

Three things make the inspector look harder. The inspector turns out to be the contractor’s cousin, a conflict of interest. The permits were forged, which is bad faith. Or the owner approved the plans after skimming a single page, with no informed decision at all. Then the inspector stops deferring and asks the owner to prove the whole job was fair, in both the dealing and the price. This is called entire fairness review.

Where the picture stops working

An inspector stands outside the household, while a court is asked after something has gone wrong, with the benefit of hindsight: precisely the temptation the rule resists. The rule is not a statute but a doctrine of state corporate law, best developed in Delaware, and other states differ in detail. Many corporations’ charters also limit directors’ liability for careless, though not disloyal, decisions.

How it really works

  1. 1Identify the decision and who made it: directors, or officers acting within board authority, exercising business judgment.
  2. 2Start from the presumption that they acted on an informed basis, in good faith and in an honest belief that the action was in the company’s interest. The challenger bears the burden of rebutting it.
  3. 3Look for the routes of rebuttal: a conflict of interest or lack of independence (duty of loyalty), bad faith, a failure to be informed (gross negligence in the decision process, under the duty of care), fraud or illegality, or waste.
  4. 4If the presumption is rebutted, the burden shifts: the directors must prove the transaction was entirely fair. If it is not rebutted, the court does not review the substance.
  5. 5Remember the limits on liability. Statutes in many states let a charter remove directors’ personal liability for money damages for breaches of the duty of care, but not for disloyalty or bad faith.

Why people get it wrong

  • Believing courts never review business decisions. They review process, conflicts and good faith, and decisions tainted by any of them.
  • Treating a bad outcome as proof of a breach. The rule exists to prevent liability being judged by results.
  • Mixing up care and loyalty. The rule protects careful, disinterested decisions; a self-interested decision gets entire fairness review.
  • Assuming good intentions are enough. Directors must inform themselves of the material information reasonably available (Smith v. Van Gorkom).
  • Assuming a single national rule. Corporate law is state law, and Delaware’s decisions are influential but not universal.

A worked example

The facts are invented

The board of the invented Northfield Mills approves the sale of the company at a fixed price per share. The meeting lasts two hours, the only information is the chief executive’s oral presentation, no valuation was obtained, and no director has read the agreement. Shareholders sue. In a case with facts like these, the Delaware Supreme Court held in Smith v. Van Gorkom that the directors had not informed themselves adequately, and the presumption did not protect them.

Compare a board that met several times, took advice from independent bankers and read the draft before approving a sale at a price that later looks low. That decision stays protected, even though it may have been a poor bargain. And if one director secretly owned part of the buyer, the conflict would remove the presumption for the decision, whatever the process, and the directors would have to prove its fairness.

Try it

Directors with no personal interest approve a risky expansion after receiving detailed reports and discussing alternatives over several meetings. The expansion fails and the company loses a great deal of money. Are the directors liable for the loss?

Landmark authorities

Read the sources themselves; this list is a starting point.

  • Dodge v. Ford Motor Co., 204 Mich. 459, 170 N.W. 668 (1919)
  • Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983)
  • Aronson v. Lewis, 473 A.2d 805 (Del. 1984)
  • Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985)

Where to go next

More hard concepts in United States law

This page is an educational overview. It is not legal advice and not a substitute for the sources: the statute, the rule, the case itself. United States law is made in fifty states and in the federal system, and the rules differ between them. Each page states the usual formulation of the rule and names landmark decisions; your own state, circuit or course may use different wording. Check the primary sources before relying on any rule.