Business Judgement Rule Defined & What it Means!

Denise Elizabeth P
Senior Financial Editor & Contributor
Last Updated: July 7, 2021
Date Published: July 7, 2021

What is a business judgement rule you may ask?

The business judgement rule is essentially a shield that protects the board of directors (B of D) against legal allegations that are more often trivial than not regarding the way the company or corporation conducts its business operations.

The business judgement rule is considered a legal staple within countries that practice common law.

The business judgement rule indicates that the board of directors are conjectured and anticipated to act and function in good faith.

What acting in good faith would pertain to is that the board of directors are inferred to operate within the fiduciary to standards of care, prudence and loyalty that the board of directors owe to its stakeholders.

Operating within fiduciary standards entails acting on behalf of the stakeholders to place the stakeholder’s interests above their own with the obligation to maintain trust and good faith.

Standards of fiduciary comprise of what is known as the “duty of loyalty” and the “duty of care”.

The duty of loyalty establishes that the board of directors need to put the interests of the stakeholders and the corporation as a whole over their own interests or the interests of those other than that of involved stakeholders and the corporation.

The duty of care obligates the board of directors to act on a basis that is well informed.

May there be a lack or complete absence of evidence to prove that the board of directors have flagrantly breached or infringed a rule of conduct, the courts will automatically dismiss any questions to the board of director’s decisions and will not even consider to review the case.

Business judgement rule

Understanding the Business Judgement Rule

The business judgement rule recognizes that conducting business and running its operations daily in respect to its strategy for the long term would need to have the board of directors make certain decisions that are not always easy.

In fact, there will be decisions made that may be flagged as controversial and there will be actions that will be taken in pursuit of furthering stakeholder interests that would put the company or corporation at risk.

It has to be noted that every business decision is risky to one extent or another especially when its growth is sought after which may involve decisions that play on calculated risks like the acquisition or buying of another company and the launch of a new product or service line of the business.

It is understood that generally, greater risks will need to be taken when aiming for higher profits.

The underlying principle to the business judgement rule is that the board of directors should be permitted to make the decisions necessary to further the company or corporation without the fear of being prosecuted by its shareholders who have the ability to object to the decisions they make.

The business judgement rule takes into account that managers cannot be expected to always and perfectly make the best and most flawless choice every single time.

So as long as the courts are under the impression that the board of directors have acted with rationality and in good faith, no actions will be taken against the board of directors for the outcomes of the decisions they have made.

An example of the Business Judgement Rule

Let us say that a company’s board of directors have been deliberating on shutting down a certain product line of theirs.

The data shows that the profit margins on the product have been plummeting resulting in the product being ridiculously expensive to produce which ends up affecting and decreasing the revenue the company earns from its other product lines.

The board of directors acting on the duty of loyalty and the duty of care ultimately decide on ceasing the production of the failing product line and completely discontinuing the failing product line all at once.

The board of directors now have resources freed from the discontinuation of a nonprofitable product line which they now allocate to the areas of the business that are more profitable.

In this example, the business judgement rule shields the board of directors from being prosecuted by invested shareholders who are unfavorably affected by their decision and from shareholders who just disagree with them.

Exemptions to the Business Judgement Rule

The business judgement rule does not absolutely protect the company or corporation’s board of directors from everything.

An example to illustrate this is if a hypothetical director chooses to sell the assets of the company at a price that is extremely discounted to the point that the company is basically being charged a loss for the sake of the said director’s family member.

This situation is an example of what the business judgement rule cannot protect the board of directors against as it is considered as self dealing where a fiduciary commits to their own best interest rather than that of their shareholders.

The plaintiff has to show evidence to prove that the board of directors have disregarded the very heart of the business judgement rule and have acted in bad faith instead.

Activities done by the board of directors which invalidate the protection granted to them by the business judgement rule include the failure to have unethical corporate behavior investigated when it is clear that it has transpired, abandoning or relinquishing corporate responsibility, having a conflict of interest or acting in a way that would be a breach of trust, and being engaged in fraud.

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Key Takeaways

  • The business judgement rule shields the companies it protects from trivial lawsuits as the board of directors are expected to act in the interest of the company or corporation and its involved stakeholders unless it has been proven otherwise without a doubt.
  • The business judgement rule implies and accepts that the board of directors will not be able to act in a way that produces the most ideal or optimum results every single time. It is not expected to have the board make decisions that are subjectively perfect during every issue or situation that the company or corporation faces.
  • The courts will not question the decisions made by the board of directors unless it has been explicitly proven that the board of directors have acted in their own self interest or have acted against the interests of the business and its involved stakeholders. The courts will also not question the decisions made by the board of directors unless it is proven that the board of directors have violated the law.

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  1. William & Mary Business Law Review "The Business Judgment Rule as an Immunity Doctrine " White paper. July 7, 2021

  2. Harvard Law School Forum of Corporate Governance "The Importance of the Business Judgment Rule" Page 1 . July 7, 2021