The Business Judgment Rule

In this post, I discuss the business judgment rule and the legal liability protections that it provides to company management.

Photo by The Elite Ayrshire Business is licensed under CC 2.0.

Business, by its very nature, is full of risks. Even if you do everything right, evaluate every situation carefully, and execute perfectly, things may not work out. Successful entrepreneurs often have their own stories of failure. (Consider, for example Donald Trump’s troubles in the 1990s.)

Understanding this, the law allows for some leniency to directors, preventing them from being held personally liable for business decisions that do not turn out well. Who would want to be a director or officer of a company if a shareholder could sue them personally if the business did not do well?

The Business Judgment Rule

The business judgment rule protects directors and officers from legal liability for the results of their good faith business decisions. (If there is proof that the decision was made in bad faith, the protection does not apply.)

The rule essentially states that a member of the board of directors or an officer of a corporation cannot be held personally liable for the losses of the company suffered as a result of their decisions resulting from a good faith business judgment.

Elements of the Rule

To qualify for this protection, the following elements must be present:

1. The individual in question must be an officer or director.
2. Only an affirmative business judgment qualifies as a business judgment under the rule. Failures to act or judgments motivated by something other than business concerns do not qualify for the protection from liability.
3. The judgment must be made in good faith.
4. The director or officer must be disinterested—that is, have no personal interest in the decision—, the director or officer must be reasonably informed, the decision must be rationale, and the director or officer must rationally believe that the business judgment is in the best interest of the business.

The Business Judgment Rule provides a large amount of deference to the decisions of the company’s leadership. This can be difficult to overcome when a shareholder is seeking to file a derivative suit on behalf of the company. It does, however, help encourage individuals to lend their expertise to businesses when requested.

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See Also:

The Shareholder Derivative Suit

Shareholders and Directors