What is the Business Judgment Rule?

Mary McMahon

In the United States, the business judgment rule is an aspect of corporate case law which states that the board of directors of a corporation will not be held liable for mistakes it makes if the decisions behind the mistakes were made in good faith. The idea behind this rule is that doing business inherently involves making decisions which may be controversial or risky in nature, and that boards of directors might not be able to act freely if they had to be constantly concerned about the potential for suit from shareholders.

Businessman giving a thumbs-up
Businessman giving a thumbs-up

Several standards must be met in order to confirm that the members of a board of directors cannot be challenged. The entire premise of the business judgment rule is based on the idea that the members of the board always work in the best interests of the company. In addition to being legally obligated to do so, they have a vested interest in keeping the company in good financial health because their pay is often based on performance.

Decisions must be made in good faith, must be reasonable, and must be made under the belief that they were made in the best interests of the company in order for the business judgment rule to apply. For example, the board of directors could spin off a low performing unit of a car company because they believe that it would be best for the company to sell that brand than to try and resuscitate it. A shareholder could believe that this decision was wrong, but the board members could not be challenged if they could show that they acted in good faith, felt that the choice was right for the company, and that their decision was reasonable and prudent by industry standards.

Members of the board have a duty of care to the parent company. If there is a belief that misconduct occurred, they can be taken to court by a shareholder or, more commonly, a group of shareholders. The business judgment rule is used to review such cases to determine whether or not people have a suit. If they do, the board of directors will be held accountable for the decisions they made and asked to demonstrate their reasoning.

Some people have challenged the business judgment rule under the argument that it effectively insulates board members from liability and that it can be abused. In 2009, there were some attempts to lobby for a rethinking of the rule on the grounds that standards such as this permitted questionable business practices which contributed to the global economic meltdown which started in 2008.

You might also Like

Discuss this Article

Post your comments
Forgot password?