What Is the Business Judgment Rule?

The business judgment rule helps to guard a corporation's board of directors (B of D) against frivolous legal allegations about the way it conducts business. A legal staple in common law countries, the rule states that boards are presumed to act in "good faith"—that is, within the fiduciary standards of loyalty, prudence, and care directors owe to stakeholders. Absent evidence that the board has blatantly violated some rule of conduct, the courts will not review or question its decisions.

Fiduciary standards include the "duty of care" and the "duty of loyalty." The first is an obligation to act on an informed basis. The second requires directors to put the interests of the corporation and over their own self-interest or the interests of others.

Key Takeaways

  • The business judgment rule protects companies from frivolous lawsuits by assuming that, unless proved otherwise, management is acting in the interests of the corporation and its stakeholders.
  • The rule assumes that managers will not make optimal decisions all the time.
  • Unless it's clear that directors have violated the law or acted against the interests of the firm and its stakeholders, courts will not question their decisions.
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Bad Faith Insurance Definition

Understanding the Business Judgment Rule

The business judgment rule acknowledges that the daily operation of a business, as well as its long-term strategy, requires making controversial decisions or taking actions that put the company at risk. All business decisions are to some extent risky, whether they involve starting a new line of business or buying another company. Generally speaking, higher profits require taking greater risks.

The principle underlying the rule is that the B of D should be allowed to make such decisions without fear of prosecution by shareholders who might object. The rule assumes that it is unreasonable to expect managers to make optimal decisions all the time. As long as a court believes that directors are acting rationally and in good faith, it will take no action against them.

Example of the Business Judgment Rule

Say that XYZ Company's board is considering shutting down a particular product line. Profit margins on the product have been shrinking and the product is becoming extremely costly and eating into revenues from other business lines.

The board decides that discontinuing the product would free up resources necessary to focus on more profitable areas. In this case, the business judgment rule protects directors from prosecution by shareholders who disagree with their decision or who are adversely affected by it.

Exemptions to the Business Judgment Rule

By contrast, there are instances in which director decisions can end up in the courts. For example, a director sells a company asset to a family member for an unjustifiably low price. This would be an example of self-dealing that the rule would not insulate from prosecution.

In order to challenge the presumption that is the heart of the rule, plaintiffs must show evidence that directors have acted in bad faith. This might include engaging in fraud, committing a breach of trust or creating a conflict of interest, abdicating corporate responsibility, or failing to investigate unethical corporate behavior that is obvious when committed.