I wager that most readers of this post misunderstand the “business judgment rule” in some important regard, regardless of years of practice experience and whether you are a transactional or litigation corporate lawyer. It is not your fault, however, and so I won’t actually take your money when I win the wager. I will only ask that you support my proposal to bring conceptual clarity and consistency to application of the rule.
Entire books and even multi-volume treatises have been written about the business judgment rule; analysis of it is a de facto “cottage industry”. Regrettably, that commentary mostly rationalizes the conceptual confusion brought on by decades of misunderstanding and frequent misapplication of the rule. Conceptual clarity and straight‑forward application is nonetheless possible, and it is needed, unless one supports the current state of affairs as a way to subvert or marginalize the rule.
Because of the large volume of commentary on the rule, most corporate lawyers believe they know its historical conception and objectives, A brief review will both dispel that notion and set the stage for my clarifying view of how the rule was intended to (and should) operate.
Overview and Conceptual Fundamentals
The historical baseline conception of the business judgment rule is that the substantive merits of business decisions made by directors are afforded protection from second-guessing by courts, so long as the directors reached those decisions through deliberations and other procedural processes that satisfied their fiduciary duties under state law. That baseline reflects an underlying policy position that directors’ fiduciary duties do not subject their decisions to strict liability. Directors can be wrong in deciding some matter and yet not have their decision overturned, if the directors were loyal, careful and followed certain rigorous procedural protocols in making it. As so conceived, the business judgment rule was intended to be a protective measure for directors who acted properly, even though they may have gotten something wrong.
If that is your understanding of the historical conception of the rule, you are correct, so far. My analysis of the leading cases indicates that things begin to get off-track — leading to confusion, complexities and problems — because of well-intentioned courts, trying to “do good”, in situations with “bad facts” that cried out for equity. In any event, that baseline conception has been frequently distorted to such an extent that some courts and commentators have come to refer to the rule as a legal standard for conduct and/or an actual duty or responsibility owed by directors or a board. It was neither.
Rule of Procedure — Rebuttable Presumption
Properly understood, the business judgment rule was (and I believe it should remain) a rule of procedure that establishes the following, fairly straight-forward, rebuttable presumption. In making a business decision, directors are presumed to have acted in accordance with their fiduciary duties if the directors followed certain procedural protocols. The presumption is not that the directors’ decision was substantively correct, but simply, albeit significantly, that the directors fulfilled their fiduciary duties in making it. If so, the decision is entitled to be respected and not be second-guessed simply because it looks or feels wrong with hindsight. Such presumed fulfillment of fiduciary duties can be rebutted, of course, by persuasive factual evidence that the directors’ fiduciary duties were not actually fulfilled. If they were not, then a second-guessing review of the substantive merits of the decision is appropriate.
Some courts (with Delaware courts typically in the lead) have allowed a so-called enhanced presumption of propriety in certain situations, such as where a majority of the board of directors making a particular decision are independent directors, or where a special committee of independent directors is appointed to decide the particular matter. It is arguable, but essentially unimportant here, whether such a putative enhancement is useful. The key point is that, in all situations, the decisions of disinterested directors should be entitled to the presumption of propriety afforded by the business judgment rule, if those directors followed appropriate procedural protocols.
Even in the conceptual confusion currently surrounding the rule, the elements of those protocols are fairly well‑established as meaning that the directors:
- make an affirmative decision to act or refrain from acting, as opposed to defaulting to a particular result by not making a decision;
- act in good faith;
- act in the honest belief that their action is in the best interest of the company;
- stay informed of all material facts, and proceed with care and circumspection in their decision-making processes; and
- have a rational business purpose for their decision.
With a caution about the last element — i.e., it is not really a separate element, but is the de facto cumulative effect of the other elements being present — those elements are a good and effective set of procedural protocols for application of the rule. They are qualitative and rigorous as a basis for testing the directors’ fulfillment of their fiduciary duties, and thus for determining whether the presumption should be sustained, without getting into the substantive merits of the underlying decision.
Two‑Step Approach for Rebutting the Presumption
Whether the presumption of the rule is sustained or rebutted is a two-step process. As the first step, the plaintiff must present credible factual evidence indicating that a breach of a fiduciary duty occurred, based on one or more of the above procedural protocols. The plaintiff’s threshold rebuttal presentation leads to the second step, by shifting to the defendant directors the burden of producing countering evidence that they actually discharged their fiduciary duties in making the decision.
In the second step, the court assesses the competing evidence, based on the satisfaction or not of above procedural protocols only. If the defendant directors’ countering evidence is more persuasive than the evidence presented by the plaintiffs, then the decision should be respected and accepted, and the substantive merits should not be second-guessed by the court. On the other hand, if the evidence provided by the defendant directors is not persuasive, then the court should turn to analyzing the substantive merits of the decision using the relevant standard for such a substantive review under applicable law.
Regrettably, consistent compliance with that two-step approach has not been the norm. Instead of assessing and weighing the evidence presented by the two sides, and then abiding by the outcome of the determination whether the directors proved that they satisfied their fiduciary duties, courts have often undertaken a review of the substantive merits of the decision, without making (or regardless of) that determination. Again, I believe that occurred because the courts were actually peeking, during the second step, at the perceived or suspected “inequity” of the decision’s substantive outcome and trying to get around the rule. While I can understand that temptation, it simply is inconsistent with the rule as conceived.
Most of the leading commentary (and many subsequent courts) have sought to rationalize such cases, rather than recognizing the departure from the historical conception of the business judgment rule, typically in one or both of two problematic ways: (1) reading such cases to mean that the rule per se is not considered to be applicable to those particular situations; or (2) indicating that the rule itself actually permits the court to second-guess the substantive merits of a decision in some situations, whether or not the directors proved that they actually satisfied their fiduciary duties. From there, it has been a fairly short step for many to begin describing directors’ action in such a situation as being “outside” the business judgment rule.
Such analyses and descriptions — whether they are misguided rationalizations or intentional attempts to subvert or marginalize the business judgment rule — distort the original conception of the rule and introduce confusion and uncertainty. It is one thing to take a straight-up, principled position that the rule is being abandoned or radically changed, but it is disingenuous and unhealthy to claim that such analyses and descriptions are consistent with the rule as conceived. Unless and until the former is done through proper channels, and for policy reasons that are clearly established, we should insist upon clarity and consistent application of the business judgment rule as it was conceived.
Proposal for Conceptual Clarity
Despite the current state of complexity and confusion, the business judgment rule can be made clear via an approach that it is both straight-forward and fair to all constituents. Doing so requires cutting the Gordian knot into which the rule has been tied by a legion of misguided (or perhaps intentionally marginalizing) cases and commentary. It begins with establishing the following two-part precept for the rule:
(1) All properly challenged decisions of directors will be subject to a review of the substantive merits (i.e., second-guessing) if a breach of a fiduciary duty by the directors is proven, but no directors’ decision will be second-guessed in the absence of such proof; and
(2) There will be a rebuttable presumption in all situations that the directors complied with their fiduciary duties, unless the subject decision was taken by less than a majority of the independent directors.
Implicit in the second part is that there is no presumption of propriety by the directors where a challenged decision was made by less than a majority of disinterested directors. In such situations, there is no presumption to be rebutted — in other words, such decisions would truly be “outside” the business judgment rule. Where the presumption is applicable, the basic precept would operate with the two-step rebuttal approach discussed earlier, and the current procedural protocols I also discussed earlier would continue to apply.
My proposed approach would benefit both shareholders (potential plaintiffs) and directors (potential defendants). Plaintiffs would be assured of being able to challenge the substantive merits of any decision they believe was wrong, if they can prove an actual breach by directors of a fiduciary duty. That ability is currently uncertain, as a practical matter, in the confusion of the current state of affairs. Directors would avoid the use of possible distortions of the business judgment rule to expand the zone of de facto strict liability in certain situations, which can potentially become the practical effect of not accepting and following the outcome of the two-step rebuttal approach.
A Threshold Policy Matter
Despite its mind-numbing complexities, distortions and resulting confusion, the prevailing view of the business judgment rule has held sway for several decades. It will be difficult to correct and reorient for that reason alone. Moreover, because my proposal would actually help to fortify the rule, it has an underlying policy implication, and that could be a legitimate basis for resistance. In other words, as alluded to above, the current confusion and uncertainty may be the desired result by some who want to subvert or marginalize the rule for policy reasons. While such a policy position may have merit, it should be presented straight-up and in the open, and should not be advanced by subterfuge.
The virtue and acceptability of a protective presumption about anything presupposes confidence in the integrity and rationality of the thing to which or for whom the presumption is afforded. Because the business judgment rule, at its essence, is a presumption about the propriety of directors’ actions in performing their fiduciary duties, a fortification of the rule is a policy position. I believe it is an appropriate and beneficial policy position, notwithstanding that confidence in much of corporate America, including corporate directors, has been shaky in the wake of numerous corporate scandals of which we are all aware. As a result, supporting my proposal may require a profile in courage. But, I expect no less if you took, and therefore lost, my wager.