The business judgment rule may be the most enigmatic doctrine in corporate law, but it has always performed a relatively straightforward task in the corporate governance system of the United States, namely, protecting corporate directors from liability for honest mistakes. The words that courts use to convey that simple idea have varied greatly, but perhaps none are more confusing than the words most often employed in the Delaware courts: “The business judgment rule … is a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the corporation.” Commentators have puzzled over the language of presumption, recognizing that the business judgment rule must be more than a procedural guide. Indeed, the Delaware courts have often said that the business judgment rule is both a procedural guide, dictating the terms of the plaintiff’s first move, and, if the plaintiff fails to meet evidentiary burden, a substantive rule of law, protecting the substantive merits of the board’s decision from judicial review.
The traditional business judgment rule applies when directors are reasonably informed about their decision, disinterested and independent, and acting in good faith. In the 1980s Delaware courts began assigning the business judgment rule a more expansive role. The “modern business judgment rule” is applied not only in cases when the board of directors acted in accord with these standards, but also 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. In these cases, the Delaware courts have created paths back to the business judgment rule when the procedural infirmities at the board level have been mitigated by a special committee, stockholder approval, or, in cases of structural conflict, by partial substantive review of the board action by the court. In these new contexts, a court must satisfy itself that a board decision is worthy of respect, not because the decision was substantively correct, but because the effect of the procedural infirmities was sufficiently muted. After the court reaches that point, the business judgment rule “attaches” to protect the substantive merits of the decision from (further) review.
The development of the modern business judgment rule has occurred in cases involving takeovers. When a board of directors contemplates a sale of the corporation, claims of procedural infirmities arise almost inevitably. Under the traditional business judgment rule, when courts moved away from cases involving a decision maker who was careful, loyal, and acting in good faith to cases with procedural infirmities, the business judgment rule became irrelevant. Under the modern business judgment rule, a court could still conclude that a decision of the board of directors would be worthy of deference under the business judgment rule under some circumstances. The Delaware courts have made innovative use of the business judgment rule in cases involving takeover defenses, controlling stockholder transactions, and stockholder ratifications.
Takeover Defenses. Hostile takeover bids place the directors of a target corporation in a precarious posture. While not in a position of direct conflict in the sense associated with self-dealing, the directors nevertheless face an “inherent conflict of interest” between their desire to maintain their board positions and their duty to serve the stockholders. In 1985, the Delaware Supreme Court issued a landmark decision in Unocal Corp. v. Mesa Petroleum Co., which held that in cases involving defensive actions by a target board of directors, the burden of proof shifts to the defendant to show both (1) that the directors reasonably perceived a threat to the corporation, and (2) that the directors’ defensive responses were proportional to that threat. Unocal described the relationship of these standards to the business judgment rule as follows:
Because of the omnipresent specter that a board may be acting primarily in its own interests, rather than those of the corporation and its shareholders, there is an enhanced duty which calls for judicial examination at the threshold before the protections of the business judgment rule may be conferred.
The notion that the two prongs of the Unocal analysis would serve as a “threshold” to the business judgment rule proved confusing to subsequent courts and commentators. If the defendant directors carried their burden under Unocal, what would be left for the plaintiff to do under the business judgment rule? Importantly, Unocal does not say that the court should complete the two prongs of analysis, then proceed to further analysis under the business judgment rule. Rather, the Unocal case proclaims that if the directors are successful in carrying their burden under the two prongs, the court may confer the protections of the business judgment rule.
Controlling Stockholder Transactions. When the sale of a company involves a controlling stockholder on both sides of the transaction, the board of directors stands in a position of conflict. Until recently, the Delaware courts have evaluated these transactions substantively under the “entire fairness” standard, making the business judgment rule inapplicable. In 2014 the Delaware Supreme Court held in Kahn v. M & F Worldwide Corp. as follows:
[I]n controller buyouts, the business judgment standard of review will be applied if and only if: (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority.
Under this standard, if the requisite conditions are satisfied, the only avenue left to the plaintiffs is an argument of substantive irrationality. As with Unocal, the business judgment rule is invoked not in the absence of procedural infirmities, but despite the initial conflict of interest. And the rule makes its appearance only after a rigorous review of the alternative processes.
Shareholder Ratification. Transactions not involving a controlling stockholder also may benefit from shareholder approval. When challenged transactions have been approved by directors who breached their duties of care or loyalty, shareholder ratification will usually invoke the business judgment rule. The application of the business judgment rule in these circumstances limits review to issues of gift or waste with the burden of proof resting upon the plaintiffs.
When serving in a fiduciary capacity, the ideal board of directors is careful and loyal and acts in good faith. The business judgment rule tells courts to uphold board decisions – even if the corporation or its shareholders are harmed by those decisions – unless a challenger can prove that the directors have violated one of these standards. The Delaware courts have transferred this basic structure of the business judgment rule from the paradigmatic case of a decision maker who is careful, loyal, and acting in good faith to the more troubling cases involving takeover defenses, controlling stockholder transactions, and stockholder ratifications. In each of these circumstances, the Delaware courts have carved a unique path to the business judgment rule. On reaching the business judgment rule, however, the result is always the same: the plaintiff is left with no further arguments (Unocal) or with an insurmountable burden of showing that the board decision is substantively irrational. Thus, the modern business judgment rule is not a one-size-fits-all doctrine, but rather a movable boundary, marking the shifting line between judicial scrutiny and judicial deference.
This post comes to us from D. Gordon Smith, the Glen L. Farr Professor of Law at BYU Law. The post is based on his recent article, which is entitled “The Modern Business Judgment Rule”, is forthcoming in the Research Handbook on Mergers and Acquisitions and is available here.