The Hindsight Bias: When the Business Judgment Rule Isn’t Enough

As a director in a corporation, you owe certain duties to other constituents in the corporation. Chief among these are the duties of loyalty and care.  Generally, the duty of care refers to using due diligence in making decisions on behalf of the corporation.  Most decisions made, if in good faith, are given very deferential treatment under the business judgment rule.  This is because the hindsight bias may blur what appeared to be in the best interests of the corporation at the time.  Essentially, directors are given a very deferential standard in which they are given great leeway to conduct their business.  However, in certain circumstances, it is clear the actions of the director were done in a poor manner, and therefore should not be availed of the business judgment rule.

There are four prongs to the business judgment rule.  First, the director must have made a decision.  Next, the director must have informed himself with respect to the business judgment he made to the extent he reasonably believes appropriate under the circumstances.  Third, the decision must have been made in good faith.  Finally, the director may not have a financial interest in the subject matter.  The director must live up to all four prongs of the business judgment rule to avail himself of its deferential treatment.

One of the main reasons for judging directors’ actions by the business judgment rule is because they have conducted their due diligence in coming to a decision.  The business judgment rule presumes that the procedure a director or officer used in coming to his or her decision was one of careful thought and consideration.  While the outcome may not have been optimal, the procedure protects the director or officer.  However, if it is clear that the outcome was the result of lack of consideration and improper procedure, the director will not be able to avail him or herself of the business judgment rule.  Improper procedure, therefore, is one scenario where the business judgment rule will be inapplicable.

There are other scenarios whereby the business judgment rule will not work.  If the director is interested in the subject, it is clear that his duty of loyalty will be questioned. Therefore, directors cannot avail themselves of the deferential standard when there may be some ulterior motive.  Another scenario whereby the business judgment rule will not work is if the director is uninformed in his decisionmaking.  If fraud, illegality, nonfeasance, lack of rational business purpose, or gross negligence has taken place, the business judgment rule will not apply.  Finally, if the director does not truly believe that the business judgment is in the best interest of the corporation, he will be unable to avail himself of the deferential business judgment rule.

Although many decisions made by directors are given great deference, there are scenarios whereby their decisions are second-guessed in courts.  In such cases, a court must look to a director’s procedure in formulating their business judgments.  If you feel as though a director’s actions in your corporation were not well-informed or well-formulated, perhaps it is time to consult with a business attorney.  Call the Trembly Law Firm at (305) 431-5678 today to schedule a consultation.