Business Judgement Rule

This article was written by Ishika Patel, an intern with the Law Offices of Ryan Reiffert, PLLC. The business judgment rule is a crucial principle for corporate directors and shareholders to understand as it protects the jobs and assets of each respectively. This post breaks down the rule into its main points so it is easier to digest. It will go through the structure of the rule, as well as famous examples and new modifications of it. This is a general overview of the rule and relevant topics though, and I advise everyone to consult with a business attorney for personalized advice.

Duty of Care

For the Business Judgement Rule to stand, the directors must prove that they upheld the duty of care, one of their many fiduciary duties. The duty of care, as defined by Cornell Law School, is “the principle that directors and officers of a corporation in making all decisions in their capacities as corporate fiduciaries, must act in the same manner as a reasonably prudent person in their position would”. Essentially, their actions should be objectively reasonable and understandable. For example, a teacher has a duty of care to their students to educate them, but not to file their taxes; they must teach in their best ability, and in a way that other teachers and professionals in their position would. The duty of care holds a large chunk of the standards expected to be held under the business judgment rule and effectively protects the shareholders against any ill-intended or outright irrational decisions made by directors.

Duty of Loyalty

Another important principle to understand is the duty of loyalty, which, according to Cornell Law School, “stands for the principle that directors and officers of a corporation in making all decisions in their capacities as corporate fiduciaries, must act without personal economic conflict”. Essentially, directors should not make decisions with their personal financial interests in mind, but instead with the shareholders interests. An example of a failure to meet the duty of loyalty is insider trading; this act uses personal financial gain to influence decisions, violating fiduciary duties of loyalty (and care). The duty of the fiduciaries, which in this case are usually the directors, is to preserve the assets of the company’s shareholders and to assure them that those assets are safe in someone else’s hands. This principle is not as relevant to the business judgment rule as the duty of care, but it is crucial to Unocal v. Mesa, which will be discussed later on in the post.

Business Judgement Rule

Corporate directors make hundreds of decisions a day, and because of human nature, they are bound to eventually make a mistake. It is safe to assume that most people in these positions take great care and deliberation with these large decisions, whether that be out of care for the company or for self-protection. No matter how careful someone is, however, when in such a risky business there is always a margin for error that can leave directors facing lawsuits and scrutiny; this is where the business judgment rule comes in. The business judgment rule is useful for directors because if it stands in a court of law, they are given the “benefit of the doubt” of some sorts, and will not be subjected to an entire fairness review—a process where the defendant is burdened with proving that the decision made was in good standing; this process is tedious and it can be very hard to win. The business judgment rule, according to the American Law Institute, is upheld when a director or officer:
  1. is not interested in the subject of his business judgment;
  2. is informed with respect to the subject of the business judgment to the extent the director or officer reasonably believes to be appropriate under the circumstances; and
  3. rationally believes that the business judgment is in the best interests of the corporation.
If a situation in which shareholders believe the directors of their respective corporation have not upheld their duties were to occur, and a lawsuit is filed, the defendant can attempt to use the business judgment rule to avoid an entire fairness review. In this case, the plaintiff holds the burden of proving that a decision reached by a corporation’s directors was in bad faith, or violated their duty of care or loyalty that they owe their shareholders. They are required to prove that the directors violated some or all of these outlined responsibilities to prove their case. If they do prove that the directors were not fulfilling the duty of care or duty of loyalty to the shareholders, the directors’ positions could be in jeopardy and the company will be financially liable. Because the definition of the business judgment is abstract and up for interpretation, it is applied slightly differently in each American state, but the general idea is universal.

Unocal v. Mesa

A good example of the business judgment rule being used is in the 1985 case of Unocal Corp. v. Mesa Petroleum Co., a shareholder in the Unocal Corporation, offered Unocal’s shareholders a deal designed to induce a hostile takeover of the company; this was a common tactic in the 1980s, one used notoriously by Mesa’s Chairman. Mesa Petroleum designed this offer as a loaded two-tier deal to gain a controlling interest in the company. The front end of the deal contained a $54 stock buy-back, which was argued to be under-value; the back end contained junk bonds—very risky bonds that can be low-yielding. These bonds have some of the greatest returns, but also some of the lowest, and it is because of their immense risk that shareholders and investors tend to stay away from it. This deal bullies shareholders into tendering at the first tier, out of fear that they will get stuck with the junk bonds in the back, theoretically allowing Mesa’s takeover. The board of directors of Unocal then, in compliance with their fiduciary duties, discussed the action taken by Mesa and decided that it was a threat to the shareholders. Unocal’s board of directors returned with a selective self-tender offer to its shareholders stating: if Mesa becomes majority shareholder, Unocal will offer the remaining 49% of shareholders, that would otherwise be left with junk bonds, an exchange of debt securities valued at $72 a share, as well as the clause that excludes Mesa Petroleum from the proposal. The last clause is what made this case so controversial, as Mesa was still a shareholder in the company and was technically entitled to be included in the deal. This is also where the duty of loyalty comes in, as the Plaintiff claimed that Unocal would be financially interested in the deal, which violates their duty of loyalty. In addition to that, another conflict of interest arose, because once Mesa took over, they could easily replace the entire board; this is why their decision could be seen as a violation of their fiduciary duties. After the self-tender was offered, Mesa promptly sued the company, and the Delaware chancery court gave them a preliminary injunction which held that excluding Mesa Petroleum from the offer was legally impermissible. Later, the Delaware Supreme Court would overrule the Chancery court’s ruling, arriving at the famous decision. The Supreme Court held that Mesa Petroleum’s offer served as an immediate threat to Unocal and its shareholders and that the director’s response (the tender offer) was a proportional response to the said threat. This was a landmark ruling, as it expanded the traditional purpose and protection that the business judgment rule provided. Previously, the rule had not explicitly included situations where the directors had to make decisions in defense of its shareholders against potential threats, as well as the potential inherent bias that they could have in said decision.

Modern Business Judgement Rule

The original judgment rule “applies when directors are reasonably informed about their decision, disinterested and independent, and acting in good faith.”, but as time went on, a new,  more modernized rule became necessary to adapt to the more expansive ways the rule was being applied. For this reason, BYU law professor, D. Gordon Smith adapted the business judgment rule into his version of it: the “modern business judgment rule”. This adaptation adheres to all the traditional points of the original, but also adds additional protection for directors “in cases where the independence of the board of directors is potentially undermined by a controlling stockholder or where the board of directors is financially interested in the transaction”. This adaptation to the rule protects directors in cases like Unocal v. Mesa, where the directors have a clear conflict of interest or are under pressure of a potential hostile takeover.

Takeaway

The traditional and modern business judgment rules alike both have a clear purpose to protect both shareholders and corporate directors from harm. The shareholder is promised loyalty, care, and good faith, which assures that their assets are safe while in someone else’s hands. While the original rule also allows directors to make difficult, yet necessary decisions, without pressure or worry of liability, the modern rule creates an extra layer of protection for these directors, especially pertaining to inherently biased decisions. As new strategies for takeovers and malice-intended deals increase, the modern business judgment rule serves as a just layer of protection and regulations in corporate relationships.

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