If you become an officer or a director of a publicly held corporation, you will owe a duty of care to the corporation. This duty of care has three parts: (1) reasonable care; (2) good faith; and (3) reasonable belief. The reasonable care prong imposes a duty to oversee management and be informed of corporate decisionmaking; the good faith prong imposes a duty to not approve illegal, conflicting, or dishonest activity; and the reasonable belief prong imposes a duty to make decisions aimed at advancing the self-interest of the corporation.
Although these standards sound similar to negligence, they are much more stringent in application. It is extraordinarily rare for a director or officer to be found liable in court absent lawbreaking, conflict of interest, or fraud. These three rules were articulated in the 1984 Delaware Supreme Court case of Aronson v. Lewis, and although normally state court rulings are not a matter of national significance, Delaware has outsized influence because most large publicly held corporations are incorporated in Delaware and other state courts consider Delaware court rulings highly persuasive in matters of business organization law.
The reason why courts are reluctant to apply these three prongs in practice is because of a rule called the “business judgment rule” which was born during the aftermath of the Civil War and has developed since then. The business judgment rule, defined in Aronson v. Lewis, states that courts will adopt 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.” This means directors and officers are presumed to comply with the standard of care–if you are a shareholder alleging that the duty of care was violated, ambiguities will be construed in favor of the directors and officers because the courts adopt a rule that presumes the directors and officers conformed to their duty of care unless otherwise proven.
The cleanest articulation of this principle that I could find came from the 1993 Delaware Supreme Court ruling in Cede & Co. vs. Technicolor, Inc. which explained the presumption as follows: “A shareholder plaintiff challenging a board decision has the burden at the outset to rebut the rule’s presumption. To rebut the rule, a shareholder plaintiff assumes the burden of providing evidence that directors, in reaching their challenged decision breached any 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 proponents of the challenged transaction, to prove to the trier of fact the ‘entire fairness’ of the transaction to the shareholder plaintiff.”
The presumption that the business judgment rule operates is significant to directors and officers because it places a very high burden before their corporate actions will even be reviewed by a court and it also offers a substantial protection against personal liability.
The Delaware Court, in the 1996 case of Gagliardi vs. Trifoods Int’l, explained why this hurdle is so high. First, the shareholder plaintiffs may have interests that are adverse to the company. Or, at a minimum, the shareholder launching the lawsuit may not be asserting a view shared by other shareholders. Second, judges are not necessarily business experts. Presumably, someone who works for a business and has close access to the operations of a business will be able to assess risks and rewards better than a faraway judge. Third, businesses need to take risks, and this socially useful. If the standards for enforcing liability are too low, businesses will move forward with glacial caution. Fourth, people often use hindsight bias to attack decisions that seemed reasonable at the time, and the courts want to adopt a bright-line that discourages hindsight analysis. And fifth, as the threshold for personal liability lowers, qualified businessmen will become increasingly reluctant to serve.
For those reasons, corporate directors and officers enjoy a rebuttable presumption that acts as a high threshold for shareholder plaintiffs to overcome. Shareholders must prove that a director failed to act in good faith, did not believe the decision was in the best interest of the corporation, did not become informed of their oversight responsibilities, received an improper financial benefit, or acted in a conflict of interest. If a shareholder does manage to prove this, the burden shifts, and then the corporate director or officer receives an opportunity to demonstrate how the conduct was in the best interests of the corporation.
Some people make the mistake of believing that shifting the burden is enough to be victorious, but it’s not. All it does is shift the burden. Example: If you prove that a director only got hired because he was close friends with another director and the standard protocols were not followed, this will be enough to shift the burden but it will not be enough to be victorious if the hiring director can prove that he made the hiring decision to further the corporation’s interests.
As a practical matter, the best defense of shareholders is adequate diversification of their investment holdings. Also, the free market does exert some moral pressure here as well. If a manager performs poorly, the business will perform poorly and the stock will fall. This may be unsatisfactory as incompetent executives can be offset by more competent executives at the firm or underlying fundamental strengths of the business. In this case, the remaining incentive is that poor managers will gain poor reputations and this will diminish their future executive opportunities. The attenuated nature of this justice may not be satisfactory to shareholders because it does not deliver justice in their particular situation, but the courts have long held that the public policy gains achieved by adopting the business judgment rule offset this injustice along the way.
Note Well: This article should only be considered for entertainment purposes only.