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RESEARCH PROJECT ON

Business Judgment Rule


SUBMITTED TO

CORPORATE LAWS II

By

VISHNU. A.K.S.

(Regd. No.BA0140077)

SUBMITTED TO

Prof. Mr. Shankar Kaarmukilan


BUSINESS JUDGMENT RULE

Objective

The researcher objective in this project is,

1. To understand the concept of business judgement rule.


2. To know about the business judgement rule in a comparative manner.
3. If the director is protected by business judgement rule as a shield?

Research Questions

What are the powers and duties of the directors of the company?

What are the duties and liabilities of corporate directors; and second, what is the role of the
judiciary?

Research methodology

The study adopts qualitative approach, using comparative study design. The material used in the
study include legislations, judicial decisions, books, electronic/ internet sources, journal articles.
The study is principally an analysis and comparison of the legal provisions (both statutory and
common law) relating to directors duty of care, skill and diligence. All conclusions are based on
careful comparison between the corporate law in Australia and UK.

Review of literature

The researcher has extensively relied upon articles referred, the books referred. The companies act
explains the business judgement rule.
Tentative Chapterisation

CHAPTER I
Introduction

CHAPTER II
Business Judgment Rule
i)Definition
ii)Application
iii)Scope

CHAPTER III
Fiduciary Duties
i)Duty of Care
ii) Loyalty and Good Faith

CHAPTER IV

Incorporation of the rule

i)Australia

ii)United Kingdom

CHAPTER V

Conclusion
CHAPTER I

Definition of Business Judgment Rule:

The definition of the Business Judgment Rule is a difficult task. The reason why the rule is
difficult to define precisely is that courts have used the term and applied it in so many different
transactions that it is sometimes difficult to determine exactly how a court will apply it . In a
given situation the rule is an effective protective devise. Business judgment means any decision
to take or not take action in respect of a matter relevant to the business operations of the
corporation.

CHAPTER II

Business Judgment Rule

In American law, the business judgment rule finds its earliest expression in the United States in
the first half of the 19th century.1 In a well-known decision, the Supreme Court of Louisiana
decided to protect the managers in a business decision made in good faith and with no conflict of
interests.4 According to the courts view, it was irrelevant the result of the decision that is,
failure or success. Even though the rationale behind the implementation of this rule is quite
similar, the way the business judgment rule has been implemented differs across jurisdictions.
The moral hazard problem potentially generated by the use of the business judgment rule and the
waiver of the duty of care is usually solved by requiring directors to make an informed business
decision in the best interest of the corporation.2

1
Percy v Millauddon,1829
2
Thus, the directors are required to gather and assess information; and then, to make a decision in the best interest
of the corporation based on this information. Therefore, if the decision is reviewed by a court, the focus should not
be the consequences of the decision but the process in which the decision was made.
Application of BJR:

The BJR is a broad protection and covers the vast majority of decisions that a director will
encounter on a daily basis. However, the Rule, like all such protections, does have its limits.
Embedded within the rule are a series of requirements and caveats that ensure that the rule will
not be abused by directors and officers who act for the benefit of themselves or others and not for
the benefit of the company and its shareholders. Consider the following as a partial list of the
prerequisites and subtext requirements of the rule, noting that the courts often expand this set
when they feel, in their judgment, that a manager failed to act appropriately.

Exceeding the Scope of the BJR

In a general sense, there are only two possible outcomes when the scope of the BJR is exceeded.
If a director acts in such a way that demonstrates a lack of prudence or potential fraud, and the
company either does not suffer or actually benefits from the act, it is possible that no liability
will result. Essentially, it is likely to be the case that if the director has acted rashly, perhaps even
on a whim, and the company has made a profit from the otherwise inappropriate act, it is rare
that a shareholder or government official will sue as no negative consequences have
materialized.

There is, however, a more likely scenario. In the event of such a loss, and without the protection
of the BJR, the director or officer can face a variety of consequences, any combination of which
the court may see fit to exercise. Typically, the court will do what it can to roll back the effects
of the transaction, unwinding it where possible to return to the pre-transaction status quo. Absent
that possibility, the court will likely have the director removed and award damages in the amount
of any lost value to the company and, in an egregious case, punitive damages as well. Finally,
any violation of the BJR that is in violation of a statute or court order can subject the director to
criminal liability and perhaps jail time for failing to act in compliance with the requirement of
best efforts under the BJR.

What are the duties and liabilities of corporate directors; and second, what is the role of the
judiciary?

The answer to the question, the role of the judiciary, depends upon whether the business
judgment rule is seen as a standard of director liability or an abstention doctrine. The former is
the common understanding of the business judgment rule. It means that the standard of liability
is usually gross negligence and that non-conflicted directors are shielded from liability for
decisions made with good faith. The abstention doctrine contemplates that a judge will not rule
on the substance of the directors business decision, but only examine the decision-making
process to determine that it was not compromised by conflicts, bad faith or inadequate
information.

The need to have an understandable business judgment rule that is applied predictably is critical
to a countrys ability to attract investors in this global economy. The substance of any business
judgment rule will always be a function of each countrys legal structure and culture. The
emphasis here is not on the substantive content of any countrys business judgment rule but on a
recognition that stability and predictability is important.

Delaware jurisdiction

The decisions of the Delaware courts are final and authoritative on almost all matters of
corporate law in the United States because of the internal affairs doctrine. The internal affairs
doctrine recognizes that only one state should have the authority to regulate a corporations
internal affairs the state of incorporation

The fiduciary duties of directors of Delaware corporations are an equitable response to the power
that is conferred upon directors as a matter of statutory law. Those equitable fiduciary duty
precepts date back to a decision by the Lord Chancellor of England in 1742. In Charitable Corp.
v. Sutton, the Lord Chancellor explained that corporate directors were both agents and trustees
required to act with fidelity and reasonable diligence.3 Ever since the Suttondecision, courts
have consistently stated that directors of corporations are fiduciaries who must comply with the
duties of care described as reasonable diligence in the Sutton decision and loyalty described as
fidelity in Sutton.4

CHAPTER III

Duty of Care

To receive the business judgment rules presumptive protection, directors must inform
themselves of all material information and then act with care.In Delaware, the applicable
standard of care is gross negligence.5 Interestingly, in the 1742 Sutton decision, the Lord
Chancellor determined that the directors of the Charitable Corporation had failed to monitor the
corporations loan procedures in making unsecured loans to directors. He held the directors liable
for the resulting losses after concluding that their actions constituted gross negligence.

The duty of care requires that directors inform themselves of all material information reasonably
available before voting on a transaction. To become informed, a board can retain consultants or
other advisors and can be protected by relying on statements, information and reports furnished
by those advisors, if their reliance is in good faith and the advisors were selected with reasonable
care. The most significant duty of care case is the 1985 decision of Smith v. Van Gorkom. In that
case, the Delaware Supreme Court held that the directors of Trans Union had breached their duty
of care, because the board had failed to act on an informed basis.

3
Charitable Corp. v. Sutton, 2 Atk. 400, 406, 26 Eng. Rep. 642, 645 (Ch. 1742); see also Marcia M. McMurray, An
Historical Perspective on the Duty of Care, the Duty of Loyalty, and the Business Judgment Rule, 40 Vand. L. Rev.
605, 605 nn.1-2 (1987).
4
Constance Frisby Fain, Corporate Director and Officer Liability, 18 U. Ark. Little Rock L. Rev. 417, 419-20
(1996).
5
Smith v. Van Gorkom, 488 A.2d 858, 873 (Del. 1985).
Loyalty and Good Faith

In In re Walt Disney Co. Derivative Litigation, the Delaware Supreme Court held that grossly
negligent conduct, without more, does not and cannot constitute a breach of the fiduciary duty to
act in good faith. The Supreme Court acknowledged that conduct that is the subject of due care
may overlap with the conduct that comes within the rubric of good faith in a psychological
sense, but from a legal standpoint those duties are and must remain quite distinct.

In Disney, the Supreme Court held that a failure to act in good faith may be shown (1) where the
director intentionally acts with a purpose other than that of advancing the best interests of the
corporation, (2) where the director acts with the intent to violate applicable positive law,, or (3)
where the director intentionally fails to act in the face of a known duty to act, demonstrating a
conscious disregard for his or her duties.

In Stone, the Supreme Court stated:

Although good faith may be described colloquially as part of a triad of fiduciary duties that
includes the duties of care and loyalty, the obligation to act in good faith does not establish an
independent fiduciary duty. The fiduciary duty of loyalty is not limited to cases involving a
financial or other cognizable fiduciary conflict of interest. It also encompasses cases where the
fiduciary fails to act in good faith.

A director cannot act loyally towards the corporation unless she acts in the good faith belief that
her actions are in the corporations best interest.

In Stone, consistent with its opinion in Disney, the Delaware Supreme Court held
that Caremark articulated the two necessary conditions for assessing director oversight
liability: (1) the directors utterly failed to implement any reporting or information system or
controls or (2) having implemented such a system or controls, the directors consciously failed to
monitor or oversee its operations thus disabling themselves from being informed of risks or
problems requiring their attention.
CHAPTER IV

Incorporation of the rule

Due to the major collapse and failure of few in Australia in 80s Australia was going through a
development phase. The duties of care and skill i.e. fiduciary duty of the directors where under
examination and these were strengthen by adopting an objective standard

1) Australia

Section 180 of the Corporations Act of 2001 of Australia provides for the duty of care, skill and
diligence; A director or other officer of a corporation must exercise their powers and discharge
their duties with the degree of care and diligence that a reasonable person would exercise if
they:

(a) Were a director or officer of a corporation in the corporations circumstances: and

(b) Occupied the office held by, and had the same responsibilities within the corporation as, the
director or officer.

In Australia, the original subjective test for the duty of care has been replaced with an objective
standard both at common law and statute law. In AWA case (Daniels v. Anderson) the court
considered the four major aspects of duty of care: the nature of the duty, the ability for directors
to delegate, the need for directors to keep informed about the companys business, and the
standard of care for both executive and non-executive directors. Clarke and Sheller JJA
recognised that directors can and should have varied commercial backgrounds; but irrespective
of the background they have a duty greater than that of simply representing a particular field of
experience. Further, the contention that nonexecutive directors ought to be able to rely on a low
standard and one of more subjective nature was also rejected by the NSW Appeal Court. It was
emphasised that objective duty of care apply to both executive and non-executive directors.

In the case of ASIC v. Healey the Australian Federal Court of Appeal held that directors of a
company were liable for a breach of their duty of care and diligence by not noticing that the
companys financial records incorrectly classified a large number of current liabilities as non-
current liabilities. Middleton J held that the directors failed to take all reasonable steps required
of them, and acted in the performance of their duties as directors without exercising the degree of
care and diligence the law requires from them. The case highlights the importance of directors
making informed decisions and the need to apply themselves diligently and with an inquiring
mind so that they can form their own opinions.

The view of the Australian judiciary is that what is in the best interest of the company should be
decided by the directors of the companies.

2) United Kingdom

The UK was one of the first nations to establish rules governing the operation of companies.
Over several centuries UK has had a host of legislations relating to companies. However, these
statues did not contain a detailed provision describing the fiduciary duty of directors until the
Companies Act of 2006 was enacted. The common law concept of fiduciary duty of directors on
the other hand was developed by the UK courts through numerous cases. Section 174 of the
Companies Act of 2006 provides A director of a company must exercise reasonable care, skill
and diligence. This means the care, skill and diligence that would be exercised by a reasonably
diligent person with the general knowledge, skill and experience that may reasonably be
expected of a person carrying out the functions carried out by the director in relation to the
company, and he general knowledge, skill and experience that the director has.

Australia, business judgment rule is not provided in the UK Companies Act. However, it is
taken up by courts. Like the Australian Courts, the courts in UK now appreciate there is a
distinction between oversight and management which means the nature and extent of the duty of
skill, care and diligence will depend on factors such as the size, location and complexity of a
companys business and urgency of any decision. The formulations in section 174 take account
of the special background, qualifications and management responsibilities of a particular
director.

Alternative

The rule doesnt need any codification the rule could best address to its purpose if its implied by
the court and the courts follow a lenient approach towards the decision of the company directors.
however the only argument which could support it is the amount of second guessing judiciary
does in the application of the rule hence it could be said that rule as it stands is nothing but a
encourages director with extra security, which even without this rule shall protect the director
who follow their duties honestly in good faith sand for the best interest of the corporation.

CHAPTER V:

Conclusion

Australia and UK differ in many way, the Australian legislature is more active hence in time if
the rule stands out to kill the very purpose of the adoption, the modification shall be brought
about, certainly this is not the case with U.K. certainly the introduction of rule has evolved and
helped Australian directors to come out of the confusion which they faced in respect of their
duties. However clearer the position it is not a safe harbor, the only wise approach is honestly.
As in criminal law assertion is ignorance of law is no excuse similarly for directors in relation to
their duties it could be said ignorance of duties is no excuse. Hence rule aims at eradicating the
fear of the personal liability of director, however thinking of a situation where the action is
brought and the judiciary analyzing the details of the decision taken in the light of four
conditions doesnot seem to be a viable idea because sometimes the decision are taken by
individuals depending upon their nature that might be for the interest of the corporation and
might be not and every decision is not wrong or right there are grey areas, hence the rule does
not speak about those grey areas and generally the protection should be afforded in those cases

The nature of duties of director may demand the presence of a business judgment rule however
in the light of the above present arguments it would not be wrong to say that the purpose of the
rule has been suppressed keeping in mind the extra synthesis of the decision of a corporate by the
court. the starting place of the rule U.S has seen over the years that rule creates more problem
than it solves it exemplifies itself with the raised premiums and finally a change for the no
liability clause in the constitution of the company, one should not forget that even with regard to
business judgment rule the court can be very detailed and strict about applying the conditions to
be met in BJR. Hence it s evident that rule does not stands as effective a cover for the directors
as it appears to be on the onset.

The purpose of the rule is a protection against liability only if the four conditions are met,
however one does not realize the fact that in evaluating these conditions the fiduciary duties
which without the rule would have been evaluated. The law is moving towards expecting an
objective test of care, skill and diligence from both executive and non-executive directors. The
standard expected in decision making of a director is what is reasonably required of a person
having the knowledge and skill and experience required in that position. Sri Lanka needs to
develop its approach to duty of care to reflect an appropriate balance between protections on
interests of shareholders on the one hand and promotion of entrepreneurial endeavours on the
other. Such a balance will boost the corporate financial success. They can prepare and take
precaution for the challenge head of them.

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