I.  Business Judgment Rule – Generally

The business judgment rule is a judicial doctrine arising from courts’ respect for corporate self-governance, as well as their dislike for second-guessing the business decisions of corporate directors and officers. The business judgment rule has been described in Delaware case law as follows:

The 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 company.” Therefore, the judgment of a properly functioning board will not be second-guessed and “absent an abuse of discretion, that judgment will be respected by the courts.” Because a board is presumed to have acted properly, “the burden is on the party challenging the decision to establish facts rebutting the presumption.

Orman v. Cullman, 794 A.2d 5, 19-20 (Del.Ch.2002); See also, Westmoreland County Employee Retirement System v. Parkinson, 727 F.3d 719 (7th Cir.2013) (The business judgment rule establishes 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 company.).

As reflected in the above quote, the business judgment rule is part procedural and part substantive. Substantively, the rule prohibits courts from second-guessing the good-faith business judgments of corporate management. Procedurally, the rule creates a burden-shifting mechanism: a corporate decision carries a presumption of due care; but if the plaintiff demonstrates fraud, bad faith, or self-dealing by management, the presumption is rebutted and the burden shifts to the defendant to show that the challenged decision was fair to the corporation.  Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 260-6 1 (Del.1993).

Cede & Co. also described the way the presumption can be rebutted, stating as follows:

To rebut the rule, a shareholder plaintiff assumes the burden of providing evidence that directors, in reaching their challenged decision, breached any one of the triads of their fiduciary duty – good faith, loyalty or due care. If a shareholder plaintiff fails to meet this evidentiary burden, the business judgment rule attaches to protect corporate officers and directors and the decisions they make, and our courts will not second­ guess these business judgments. If the rule is rebutted, the burden shifts to the defendant directors, the proponent of the challenged transaction, to prove to the trier of fact the “entire fairness” of the transaction to the shareholder plaintiff.

Under the entire fairness standard of judicial review, the defendant directors must establish to the court’s satisfaction that the transaction was the product of both fair dealing and fair price. Further, in the review of a transaction involving a sale of a company, the directors have the burden of establishing that the price offered was the highest value reasonably available under the circumstances.

Id. at 361.  In In re Hickory Printing Group, Inc., 469 B.R. 623, 627 (Bankr.W.D.N.C.2012) the court noted that the plaintiff had alleged sufficient facts in its complaint to overcome the presumption of the business judgment rule when the plaintiff alleged self-dealing on the part of the defendants, in that they were able to get their guaranties released or indemnified as part of the transaction with a purchaser. The court also noted that the presumption of the rule was overcome when the plaintiff alleged that the defendants received a direct financial benefit from the sale of their company.

In Esopus Creek Valley L.P. v. Hauf, 913 A.2d 593 (Del.Ch.2006) the court stated that the protections of the Business Judgment Rule, in conjunction with the doctrine of independent legal significance, provides a board with substantial discretion in determining the proper method by which to structure a material corporate transaction.  Significantly, however, the court held that that discretion remains bounded by fundamental principles of equity that “necessarily limit what a board of directors can do” in its attempt to consummate a transaction. The court stated that at the heart of this mandate lies the oft-cited axiom that inequitable action does not become permissible simply because it is legally possible.

Mann v. GTCR Golder Rauner, L.L.C., 483 F.Supp.2d 884 (D.Ariz.2007) provided an extensive analysis of the “Business Judgment Rule” and discussed both the procedural and a substantive component of the rule. It also noted that to rebut the rule, a plaintiff must provide evidence that the directors, in reaching a challenged decision, breached their fiduciary duties to the corporation or its shareholders. If the plaintiff “fails to meet this [initial] evidentiary burden, the business judgment rule operates to provide substantive protection for the directors and for the decisions that they have made.” Id.

Thus, directors’ decisions will be respected by courts unless the directors are interested or lack independence relative to the decision, do not act in good faith, act in a manner that cannot be attributed to a rational business purpose or reach their decision by a grossly negligent process that includes the failure to consider all material facts reasonably available.

Id. at 903 (quoting Brehm v. Eisner, 746 A.2d 244, 264 n.66 (Del.2000).).  If the presumption of the business judgment rule is rebutted, the burden shifts to the director defendants to prove to the trier of fact that the challenged transaction was entirely fair to the shareholder plaintiff Id. (quoting Emerald Partners v. Berlin, 787 A.2d 85, 91 (Del.2001))

The presumption [is] that in making business decisions not involving direct self-interest, corporate directors act on an informed basis, in good faith, and in the honest belief that their actions are in the corporation’s best interest. The rule shields directors and officers from liability for unprofitable or harmful corporate transactions if the transactions were made in good faith with due care, and within the directors’ of officers’ authority. Quoting, Black’s Law Dictionary 293 (7th ed. 1999)

The business-judgment rule, therefore, does not operate to protect self-dealing by directors and officers.  Davis v. Dorsey, 495 F.Supp.2d 1162 (M.D.Ala.2007).  “In other words, if the defendant has engaged the corporation in a conflicting-interest transaction or has usurped a corporate opportunity, the business judgment rule will not bar a claim based on the duty of care.” Id. at 1176. According to In re Farmland Industries, Inc., 335 B.R. 398, 411 (Bankr.W.D.Mo.2005) the business judgment rule has a circularity – an officer’s or director’s good faith and informed action is presumed unless it is shown that the questioned transaction was not made in good faith or with due care, i.e., in an informed manner. Therefore, to survive a motion to dismiss based on the rule, a plaintiff must allege fraud, the lack of good faith motive or that the business decision cannot be attributed to any rational business purpose.  See also Davis v. Dyson, 900 N.E. 2d 698 (Ill.App.1 Dist.2008) where the court noted that it is a prerequisite to the application of the business judgment rule that the directors exercise due care in carrying out their corporate duties. “If the directors fail to exercise due care, then they may not use the business judgment rule as a shield for their conduct.”  Id.

In In re Lemington Home For Aged, 659 F.3d 282 (3rd Cir.2011), the court noted that the business judgment rule is based on the assumption that reasonable diligence has been used in reaching the challenged decision.  In attacking this assumption, a party might consider the following factors: (i) was the board disinterested; (ii) was the board assisted by counsel; (iii) did the board prepare a written report; (iv) whether the board was independent; (v) whether the board conducted an adequate investigation; and (vi) whether the board rationally believed its decision was in the best interests of the corporation. Id. at 292 (quoting Cuker v. Mikalauskas, 547 Pa. 600, 692 A.2d 1042, 1046 (1997).)

II.  Exceptions – Duty of Care

In In re Fleming Packaging Corp., 351 B.R. 626 (Bankr.C.D.Ill.2006) the court noted that how the business judgment rule operates may be dependent “upon which of the three primary fiduciary duties is alleged to have been breached.” Id. at 634. For example, with respect to the duty of care, the court noted that “mistakes that may be characterized as ordinary negligence will not give rise to liability due to the protection of the business judgment rule.” Id. In other words, the court will not apply 20/20 hindsight to second guess a board’s decision “except in rare cases where a transaction may be so egregious on its face that the board approval cannot meet the test of business judgment.” Id.

Such egregiousness must ordinarily be manifested in a grossly negligent decision-making process – usually a failure to include consideration of all material information reasonably available. In other words, the plaintiff must establish that the board’s decision was uninformed. More globally, the court stated, therefore, that the business judgment rule does not apply if the board (i) committed fraud, corporate waste, engaged in self-dealing, made decisions affected by a conflict of interest, acted in bad faith or with corrupt motive, or breached the duty of due care by having reached their decision by a grossly negligent process that includes the failure to consider all material facts reasonably available.  Id.

III.  Exceptions – Duty of Loyalty

In Westmoreland County Employee Retirement System v. Parkinson, 727 F.3d 719 (7th Cir.2013) the court stated that if a director breaches the fiduciary duty of loyalty, the business judgment rule affords no protection. The court went on to note that the fiduciary duty of loyalty was not limited to cases involving a financial or other cognizable fiduciary conflict of interest, but also encompassed cases where the fiduciary failed to act in good faith.”  Where “directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith.” Or, put slightly differently, “the intentional dereliction of duty or the conscious disregard for one’s responsibilities [constitutes] bad faith conduct, which results in a breach of the duty of loyalty.”  Id. (quoting Stone v. Ritter, 911 A.2d 362, 370 (Del.2006).).

In In re Troll Communications, LLC, 385 B.R. 110 (Bankr.D.Del.2008) the court stated that the business judgment rule can be rebutted by showing that “the board of directors, in reaching its challenged decision, violated any one of its triad of fiduciary duties: due care, loyalty, or good faith.”  (citing to Emerald Partners v. Berlin, 787 A.2d 85, 91 (Del.2001).).  The duty of loyalty mandates that the best interest of the corporation and its shareholders takes precedence over any interest possessed by a director, officer or controlling shareholder and not shared by the stockholders generally. Id. at 119 (citing to Continuing Creditors Committee of Star Telecomm, Inc. v. Edgecomb, 385 F.Supp.2d 449, 460 (D.Del.2004).).

To show that a director was interested, it was noted that it is normally necessary to establish that the director was on both sides of a transaction or received a benefit not received by the shareholders. Applying this analysis to the facts of the case the court stated as follows:

The facts as pied by the Trustee allege that a majority of the board had a financial interests (sic) on both sides of the transaction between Troll and Quad. He has also alleged that the remaining board member was not independent. With these allegations, the Trustee has pied facts sufficient to question the disinterestedness of a majority of the board of directors.  Therefore, the business judgment rule presumption may not be used as a basis to dismiss Count One under Rule 12(b)(6).

Id. at 120.

In In re Los Angeles Dodgers LLC, 457 B.R. 308, 313 (Bankr.D.Del.2011) the court stated under Delaware law: “the business judgment rule governs unless the opposing party can show one of four elements: (1) the directors did not in fact make a decision; (2) the directors’ decision was uniformed; (3) the directors were not disinterested or independent; or (4) the directors were grossly negligent.” In this case, the debtor argued the business judgment rule needed to be applied to a debtor’s decision to obtain post-petition financing under Section 364(b) of the Bankruptcy Code. Here, the court noted that the business judgment rule did not apply. The court noted that there was evidence that the debtor’s principal, Frank McCourt, controlled the debtor and would be personally liable to the prospective lender if the debtor did not seek court approval for the lender’s loan. Based on the fact that McCourt was not disinterested, the court needed to review the debtors’ decision to accept the loan applying the entire fairness standard, which required proof of fair dealing and fair price and terms. Id.

Ravenswood Investment Company, L.P. v. Estate of Winmill, 2018 WL 1410860 (Del.Ch.) did not specifically deal with the business judgment rule, but discussed the duty of loyalty.  Here, the complaint alleged that the defendants breached their fiduciary duties in two respects.  First, they granted overly generous stock options to themselves (as Company officers).  Second, they caused the company both to forgo audits of the company’s financials and to stop disseminating information to the company’s stockholders in retaliation for plaintiff’s assertion of its inspection rights pursuant to 8 Del.C § 220.

The court noted that directors who stand on both sides of a transaction have the burden of establishing its entire fairness. Id. at *13.  It noted that entire fairness requires a showing that the directors acted with “utmost good faith and the most scrupulous inherent fairness of the bargain.  To demonstrate entire fairness, the defendants were required to prove both fair dealing and fair price.  The fair dealing analysis concentrates on when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors and how approvals of the directors and the shareholders were obtained.  In the fair price analysis, the court looks at the economic and financial considerations of the transaction to determine if it was substantively fair.

In conducting its analysis, the court noted that the evidence revealed that there really was no “process.”  There were no board minutes or any other contemporaneous records reflecting specifically why the board decided that a grant of options was appropriate or how the board determined the number of options to be granted.  There was no indication that the board sought out the advice of outside legal, financial or compensation consultants.  Nor was there evidence that the board consulted any literature or other authoritative sources with regard to incentive compensation. Id. at *14.  The court stated:

But this Board was not disinterested; each of its members was a beneficiary (indeed they were the only beneficiaries) of the option grants in May 2005.  The need to employ conflict neutralizing measures was omnipresent here and yet the Board did nothing meaningful to ensure that the decisions it made were fair to Winmill & Co.

Id. at * 17


Matthew T. Gensburg
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