Business Judgement Rule and Shareholders Derivative

Actions

Submitted by:

Richa Nandy
Roll No.1682080
BBA LLB(B)
 Business Judgement Rule and Shareholders Derivative Actions

Abstract:

Business judgment rule is a means of protection for directors who work for the best
interest of the corporation in good faith and honestly, best called as fiduciary duties.
Directors of a company are said to be the trustees, they are entrusted with the
corporation as someone else’s property. Hence it is director’s liability to work for
companies best interest. And in turn work for the interest of the shareholders, hence
today if a director needs to work for the best interest of all, the areas he needs to
handle are large and risk driven if a claim is brought against such director who
disposes his duty in good faith for every ones best interest, the protection stands for
him from any claims in the form of business judgement rule. The rule stands best
suited for the current business realities where the risk and innovation is desired .The
importance of rule lies in the fact that it protects the directors against the derivative
claims of shareholders, if certain conditions are met.
A derivative action is a lawsuit against officers or directors brought by shareholders
on behalf of the corporation.That is, the shareholders act as representative plaintiff for
the corporation and sue the officers or directors for their actions resulting in harm to
the corporation.While the objective of such a lawsuit is to halt certain actions by the
defendants, any damages recovered in the action belong to the corporation (not the
plaintiff).The shareholders benefit indirectly as owners of the corporation.
 Business Judgement Rule

The collapses world over shook the trust and reliability of stock holders on the
director’s. Obviously leading to the codes, principles making it very strict for the
director’s to negate their fiduciary duties in common law or equity. On the other hand
it is also desired of the corporate manager to run a corporation profitably i.e. the
maximization of share value. The balance between the two areas became important
and risk driven. In this light the business judgment rule came as a rescuer for the
director’s as a means to protect against the judicial scrutiny against the risk and
innovation a director needs to do to run the corporate profitably .Business judgment
rule(BJR)1 is a means of protection for directors who work for the best interest of the
corporation in good faith and honestly, best called as fiduciary duties. In the words of
Gevurtz “In black letter, The ‘business judgment’ rule sustains corporate transactions
and immunizes management from liability where the transaction is within the powers
of the corporation (intra vires) and the authority of management, and involves the
exercise of due care and compliance with applicable fiduciary duties.”

Given that the directors cannot ensure corporate success, the business judgment rule
specifies that the court will not review the business decisions of directors who
performed their duties

(1) in good faith,

(2) with the care that an ordinarily prudent person in a like position would exercise
under similar circumstances; and

(3) in a manner the directors reasonably believe to be in the best interests of the
corporation. As part of their duty of care, directors have a duty not to waste corporate
assets by overpaying for property or employment services. The business judgment
rule is very difficult to overcome and courts will not interfere with directors unless it
is clear that they are guilty of fraud or misappropriation of the corporate funds, etc.

1
Article on The Business Judgement
Rule/www.lawteacher.net/free-law-essays/business-law/the-business-judgement-rule-business-law-essay.
In effect, the business judgment rule creates a strong presumption in favor of the
board of directors of a corporation, freeing its members from possible liability for
decisions that result in harm to the corporation. The presumption is that "in making
business decisions not involving direct self-interest or self-dealing, 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." In short, it exists so that a board will not suffer legal
action simply from a bad decision. As the Delaware Supreme Court has said, a court
"will not substitute its own notions of what is or is not sound business judgment" if
"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."

Although a distinct common law concept from duty of care, duty of loyalty is often
evaluated by courts in certain cases dealing with violations by the board. While the
business judgment rule is historically linked particularly to the duty of care standard
of conduct, shareholders who sue the directors often charge both the duty of care and
duty of loyalty violations.

This forced the courts to evaluate duty of care (employing the business judgment rule
standard of review) together with duty of loyalty violations that involve self-interest
violations (as opposed to gross incompetence with duty of care). Violations of the
duty of care are reviewed under a gross negligence standard, as opposed to
simple negligence.

Consequently, over time, one of the points of review that has entered the business
judgment rule was the prohibition against self-interest transactions. Conflicting
interest transactions occur when a director, who has a conflicting interest with respect
to a transaction, knows that she or a related person is (1) a party to the transaction; (2)
has a beneficial financial interest in, or closely linked to, the transaction that the
interest would reasonably be expected to influence the director's judgment if she were
to vote on the transaction; or (3) is a director, general partner, agent, or employee of
another entity with whom the corporation is transacting business and the transaction is
of such importance to the corporation that it would in the normal course of business
be brought before the board.
The following test was constructed in the opinion for Grobow v. Perot, as a
guideline for satisfaction of the business judgment rule. Directors in a business
should:

 act in good faith;

 act in the best interests of the corporation;
 act on an informed basis;
 not be wasteful;
 not involve self-interest (duty of loyalty concept plays a role here).

Under the Delaware General Corporation Law, the business judgment rule is the
offspring of the fundamental principle, that the business and affairs of a Delaware
corporation are managed by or under its board of directors. In carrying out their
managerial roles, directors are charged with an unyielding fiduciary duty to the
corporation.The rationale2 for the rule is the recognition by courts that, in the
inherently risky environment of business, Boards of Directors need to be free to take
risks without a constant fear of lawsuits affecting their judgment.

The presumption raised by the business judgement rule may be rebutted by

the plaintiff. "The business judgment 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.
Thus, the party attacking a board decision as uninformed must rebut the presumption
that its business judgment was an informed one." Further, rebuttal typically requires a
showing that the defendants violated duty of care or loyalty (with courts assuming
director's good faith otherwise).

If the plaintiff can show that an action should not be protected by the business
judgment rule (such as when a director decides to give over a certain percentage of
the company's profits to charity (duty of care violation) or lines his/her own pockets
with company's money (self-interest/duty of loyalty violation), then the burden will
shift to the defendant to show that the action meets the burden of good faith/rational
decision. In many cases, it is relatively easy for a director to find some rational reason
2
Article on The Business Judgement
Rule/www.lawteacher.net/free-law-essays/business-law/the-business-judgement-rule-business-law-essay.
for his actions and, with the courts using the business judgment rule, the case will
likely be dismissed (U.S. courts disdain getting involved in business matters). All
directors must have the option of vetoing the decision.

Frequently, the winning cases for plaintiffs involving the business judgment rule
involve acts constituting corporate waste. Also, note that some Board decisions lie
outside the business judgment rule. For instance, in the takeover context, courts will
apply the more stringent unocal test, also called intermediate scrutiny. Illegal
decisions are also not protected by the business judgment rule.

One of the earliest cases, Dodge v. Ford Motor Co, ruled, for example, that "courts of
equity will not interfere in the management of the directors unless it is clearly made to
appear that they are guilty of fraud or misappropriation of the corporate funds, or
refuse to declare a dividend when the corporation has a surplus of net profits which it
can, without detriment to its business, divide among its stockholders, and when a
refusal to do so would amount to such an abuse of discretion as would constitute a
fraud, or breach of that good faith which they are bound to exercise towards the
stockholders."
 Shareholder Derivative Action

A derivative action is actually3 two causes of action: it is an action to compel the

corporation to sue and it is an action brought by a shareholder on behalf of the
corporation to redress harm to the corporation. In Aronson v. Lewis, (“The nature of
the action is two-fold. First, it is the equivalent of a suit by the shareholders to compel
the corporation to sue. Second, it is a suit by the corporation, asserted by the
shareholders on its behalf, against those liable to it.”) Brown v. Tenney, derivative
action is in effect two actions: “one against the directors for failing to sue; the second
based upon the right belonging to the corporation.”). A derivative action allows
shareholders to monitor and redress harm to the corporation caused by management
where it is unlikely that management will redress the harm itself. Meyer v. Fleming,
(“The purpose of the derivative action is to place in the hands of the individual
shareholder a means to protect the interest of the corporation from the misfeasance
and malfeasance of ‘faithless directors and mangers’” (quoting Cohen v. Beneficial
Indus. Loan Corp.,) Jones v. H. F. Ahmanson & Co., (“A shareholder’s derivative suit
seeks to recover for the benefit of the corporation and its whole body of shareholders
when injury is caused to the corporation that may not otherwise be redressed because
of failure of the corporation to act. Thus, ‘the action is derivative, i.e., in the corporate
right, if the gravamen of the complaint is injury to the corporation, or to the whole
body of its stock or property without any severance or distribution among individual
holders, or if it seeks to recover assets for the corporation or to prevent the dissipation
of its assets.”). An action is derivative when brought by a shareholder on behalf of the
corporation for harm suffered by all shareholders in common. In Levine v. Smith, (“A
shareholder derivative suit is a uniquely equitable remedy in which a shareholder
asserts on behalf of a corporation a claim belonging not to the shareholder, but to the
corporation.”); Lewis v. Knutson, (“When an officer, director, or controlling
shareholder breaches a fiduciary duty to the corporation, the shareholder has no
‘standing to bring a civil action at law against faithless directors and managers,’
because the corporation and not the shareholder suffers the injury; equity, however,
allows him to step into the corporation’s shoes and to seek in its right the restitution
3
Article on Shareholder Derivative Action,www.mondaq.com/pdf/clients/87654.pdf
he could not demand on his own.”) Avacus Partners, L.P. v. Brian, (action is
derivative because it is brought by one or more shareholders on behalf of the
corporation rather than by the corporation itself) also in Katz v. Halperin,(“A proven
claim of mismanagement resulting in corporate waste is a direct wrong to the
corporation, and all stockholders experience an indirect wrong. Corporate waste
claims are derivative, not individual.”).

“Although most derivative suits involve claims by a shareholder on behalf of a

corporation, derivative suits also may be filed by members of an unincorporated
association, such as a limited partnership.” Draper Fisher Jurvetson Mgmt. Co. V,
LLC v. I-Enterprise Co.(plaintiff invested in venture capital funds, then alleged
damages in the millions as a result of the defendants’ fraudulent and negligent
misrepresentation, breach of contract, breach of fiduciary duty, etc.; court held that
most of the plaintiff’s claims were derivative and had to be brought on behalf of the
funds, of which plaintiff was a limited partner); see also Caparos v. Morton, (“Limited
partners seeking redress for the decreased value of their shares in the limited
partnership must do so in a derivative action.”). “The same factors that caused the
courts to fashion the derivative action procedure for shareholders and limited partners
thus apply to condominium unit owners. All are owners of fractional interests in a
common entity run by managers who owe them a fiduciary duty that requires
protection. Condominium unit owners are, therefore, entitled to the same
consideration by the courts as the litigants in those situations in which the courts have
historically allowed derivative actions to proceed, independent of any statutory
authority.” Caprer v. Nussbaum,.In contrast, an action brought by a shareholder for
harm done to an individual shareholder or a group of shareholders is a direct action. In
Kahn v. Kaskel,(a class action by shareholders is based upon individual rights
belonging to each member of the class); Von Brimer v. Whirlpool Corp.(if the injury
is to one of the shareholders and not the corporation, it is direct) Behrens v. Aerial
Comm., (“The distinction between a direct and derivative claim . . . turns on the
existence of direct or ‘special’ injury to the plaintiff stockholder.”).A direct action can
take many forms. See, e.g., In re Worldcom, Inc., (“Common examples of direct
actions include suits to compel the payment of a dividend, to protest the issuance of
shares impermissibly diluting a shareholder’s interest, to protect voting rights or to
obtain inspection of corporate books and records.”); The Winer Family Trust v.
Queen, (“If the injury is one to the plaintiff as an individual shareholder, as where the
action is based on a contract to which the shareholder is a party, or on a right
belonging severally to the shareholder, or on a fraud affecting the shareholder directly,
or if there is a duty owed to the individual independent of the person’s status as a
shareholder, the shareholder may assert a direct action on his own behalf.”);
Lefkowitz v. Wagner,(held that partners in a general partnership have a right to bring
individual suits against fellow partners; analogizing the position of a general partner’s
suit “to a suit by a minority shareholder against the majority shareholder, claiming
that the latter has violated the fiduciary duty that such a shareholder, especially in a
closely held corporation, owes to minority shareholders.”).