What is the business judgment rule?
The business judgment rule: Joel Fischer, attorney-at-law, explains what is the business judgment rule and shares best practice on decision making.
How can the business judgement rule reduce liability lawsuits?
The Business Judgment Rule protects companies and their board of directors from liability lawsuits. It assumes that, unless proved otherwise, senior management and the board of directors acted in the interests of shareholders.
The principle underlying the Business Judgment Rule is that the board of directors should be allowed to make decisions without fear of prosecution by shareholders. The rule assumes that it is unreasonable to expect directors to make optimal decisions all the time - as long as courts trust directors to have acted in good faith, they will not take legal action against them.
Under the Business Judgement Rule, the courts allow for the discretion of the board of directors to review business decisions, if the following requirements are met:
- There are no conflicts of interest
- The decision is formally correct: it was made by the responsible body and it is compliant with all regulations (e.g. approval quorums)
- The decision is made based on appropriate information, which was evaluated in a proper decision making process.
In the case requirements are met, the court reviews the content of the decision with restraint. Conversely, when requirements are not met, the court discards the restraint and takes on a strict review of the content of the decision.
How can the Business Judgment Rule reduce liability lawsuits?
Most of the time, the company's management submits a proposal to the board of directors to evaluate. In some cases, the proposal is also prepared by one of the board members. Either way, it must be reviewed by the entire board of directors who will make an appropriate decision considering certain requirements.
From a legal perspective on the decision making process, the primary question that should be asked refers to the bases that were used and reviewed, to make sure that the decision-making was performed with care. It is not about whether the decision was 'good' or 'successful', but whether it was taken carefully. This is important to prevent liability lawsuits.
To benefit from the Business Judgment Rule, which considerably reduces liability risk, the board of directors observes specific requirements when preparing the decision. In the event that the board of directors does not meet the compliance requirements of the guidelines, the risk of becoming liable is large. Failing to comply can put the board of directors in a situation where they would run short of explanations in case of liability lawsuits. Particularly, if the decision turned out to be detrimental and the company fell into financial difficulties.
Requirements in the decision making process that help the board of directors against liability lawsuits
The decision making process and the information used in the same process follow requirements that complement each other, and cannot be separated. If requirements are met, it will help protect the board of directors against liability lawsuits.
To comply, board members can rely on a checklist, which can be used during the decision making process. In continuation, elements of the checklist are presented below.
1. The starting position: defining and analysing the problem
The board of directors should have an understanding of the starting position in a decision making process. This helps with defining a clear statement of the problem and setting of a goal which indicates a careful decision making process. It also helps with re-establishing the facts relevant to the decision from the start. In doing so, the board of directors should answer the following questions:
- What is the problem? Which are the key factors that influence the problem?
- What should we achieve? What are the characteristics of a good solution?
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2. The consideration position: weighing different alternatives for action
Creating various alternatives
Before making a decision, creating several alternatives helps clarify the scope. An empirical study (1) demonstrated that the quality of decisions is greater if instead of two, three alternatives are created. This is explained by the fact that the third alternative makes the pros and cons of the other alternatives clearer.
If management only presents an approach, without forwarding an alternative, it can raise alarm signals and suggest that this is more beneficial to management than the company. Without undermining the Business Judgment Rule, it is debatable whether the board of directors must look for different alternatives before making a decision.
Failure to create alternatives, in my opinion, does not generally represent a breach of duty. However, in view of the legal uncertainty and the fact that creating alternatives enhances the quality of the decision, it is advisable to consider different approaches.
Describing the alternatives
The board of directors should be aware of the aspects and effects of the alternatives for action. An important aspect to consider is whether or not the decision is compatible with the company’s financial circumstances. For major decisions, if possible, a viable financial framework should be created, showing the alternatives' effects on the asset, financial and profit situation.
Evaluating the alternatives
The SWOT analysis: Management might have incentives to withhold or gloss over the disadvantages and risks of a preferred alternative action, so that the board of directors accepts the proposal. It is important for the board of directors to make sure that, for all alternatives, negative aspects and risks are sufficiently discussed.
The board of directors must notice if there are indications that management’s preferred option resulted in alternatives that can't be measured by the same yardstick in the decision making documents. This could lead to a distortion of the information in favour of management's preferred option.
To avoid this from happening, strengths, weaknesses, opportunities and threats need to be evaluated carefully within a SWOT analysis. Soft factors such as the expected profit or other financial effects are also relevant for the scope of the analysis.
The risk control: The board of directors should consider all possibilities to control and limit risks to avoid liability lawsuits. If the board takes measures to limit these risks, their action can, to some extent, be justified by a less precise analysis of the risks. The reason for this is that precautions were taken to prevent risks from occurring in the first place. Contractual regulations like guarantees, right to adjust prices, right of revocation can somewhat compensate for the investigation of specific aspects in less detail.
Risks should always be considered in light of the tolerance and appetite for risk within the company. If the company’s financial stability (e.g. cluster risks) is threatened, then risks must be considered in detail and, where appropriate, should not be taken.
Significant assumptions: A central component of forming an independent opinion is that the board of directors must review assumptions, and form its own opinion. Thus, the board of directors should take note that assumptions have a large potential of distorting information. In particular, for important decisions that rely strongly on assumptions, the board of directors should create various scenarios and perform a sensitivity analysis. Yet, if assumptions turned out to be incorrect, if they were reasonable, this would not result in a breach of duty of care.
3. The actual decision
The board of directors must assess and contrast opportunities and risks, strengths and weaknesses. In the evaluation of the financial aspect of a project in particular, it is advisable to determine its net present value. If several alternatives for action are compared one to another, the criteria for the decision should be clear for the decision making process. It is advisable also to record the rationale and document the decision making process, to have the evidence in case of liability lawsuits.
If a board member asks for additional information, and the board of directors refuses their request, the board member should insist on the fact be recorded. They can then have the proof that their intention was to follow an appropriate decision making process, which was overruled by the board of directors. In such cases, the legal situation can be precarious. If the board member feels that the board of directors is not performing its duties properly, the recommendation is to seek legal advice. Additionally, it is beneficial to document measures related to conflicts of interest as well as the actions taken to comply with formal regulations.
A critique on the Business Judgment Rule
The Business Judgement Rule bases itself on the assumption that it is possible to separate the decision
from the question of whether the information used, and developed, in the process of decision making was appropriate. If agreed that the information was appropriate, the judge should only review the content of the decision with restraint.
In my opinion, this construction is based on a misconception about the decision making process since the content of the decision derived directly from reviewing the information during the process. When the judge evaluates the content of the decision, he is only assessing the review of the information used during the decision making process.
Therefore, it is by chance if the judge asks a question on the information used and the decision making process or on the content of that decision. For example, a verdict stated that the board of directors made a decision to grant a loan based on insufficient information, even though the borrowers had a reputation of being "crooks and multiple bankrupts". The Federal Court found that the board of directors should have gathered additional information on the borrowers’ creditworthiness, and that the prerequisites for the Business Judgement Rule were not met (2). Yet, we could also argue that the content of the decision was inappropriate and, by granting the loan to the apparent crooks, the board of directors took a great risk. The Federal Court also ruled the same verdict in another case (3).
Thus, leaving the allocation to chance is arbitrary and creates legal uncertainty. It is, however, relevant as the content of the decision should be reviewed with restraint, whereas the information and the decision making process with strict scrutiny. As the judge performs a strict examination of the information - which extends to the content of the decision - there is a risk to undermine the protective effect of the Business Judgement Rule.
In my opinion, it would be sensible to restrain from the dichotomy between the content of the decision and the review of the information. Instead, the judge should review with restraint the entire decision making process. And examine whether the essential information was reviewed in the course of the decision making steps mentioned, and whether the content of the decision was reasonable. The board of directors should be allowed to use sufficient judgment throughout the entire process.
1 HAUSCHILDT JÜRGEN, Number of alternatives and the efficiency of decisions, Schmalenbachs Zeitschrift für betriebswirtschaftliche Forschung, 1983, 111.
2 Verdict 4A_97/2013 (28.08.2013) deliberation 5.3.
3 Verdict 4A_626/2013, 4A_4/2014 97/2013 (08.04.2014) deliberation 7.3; for more details on the whole issue, see Fischer Joel, information and responsibility of the Board of Directors (forthcoming).