The "business judgment rule" is a safe harbor for the directors of a corporation. A director's decision is not subject to review in court so long as it meets all four of the following criteria:
- It is made in good faith.
- It is made on an informed basis.
- It is made in the best interest of the corporation.
- It is made absent a conflict of interest.
Note that a decision will not automatically be overturned if it fails to meet these criteria. The business judgment rule only provides that the directors won't be held personally liable for a breach of their fiduciary duty so long as their decisions meet the criteria. If all of the criteria aren't met, the safe harbor disappears, but the breach of the directors' duty still has to be proven separately. It works like this:
- Directors make a boneheaded decision.
- Shareholders file a derivative suit to halt the decision and recover damages from the directors individually.
- Shareholders must show that the decision fell outside the business judgment rule, by proving that it failed to meet one or more of the criteria.
- If unproven, the suit is dismissed.
- If proven, the directors must show that they were fulfilling their fiduciary duties: the duty of care, duty of loyalty, and duty to be informed.
- If proven, the suit is dismissed (but the directors might have trouble finding work in the future, since their business judgment has been questioned by a court).
- If unproven, the shareholders can recover their damages.
Some real-world examples of the BJR in action:
- A man named Mullins built a system of water pipes around Rockaway Beach in Queens, New York, and sold the system to a water company in which he owned stock, at a price almost twice the construction cost of the system. A dissident shareholder sued, but the court refused to overturn the transaction. (See Gamble v. Queens County Water Co.)
- In 1919, the Dodge brothers, minority shareholders in Ford Motor Company, tried to stop Henry Ford from embarking on a major expansion plan that would dramatically cut their dividends from the company. The court refused to enjoin the expansion. (See Dodge v. Ford Motor Co.)
- Starting in 1942, the Celanese Corporation started an expensive marketing campaign in which the company president's wife got paid to sing in a radio program. Some shareholders sued: the court refused to intervene, stating that the expense of the campaign was wholly business judgment, and that the conflict of interest was not discernible because the shareholders had failed to "show that the program was designed to foster or subsidize (her) career... or to furnish a vehicle for her talents."
- A shareholder of the Chicago Cubs' holding company attempted to sue Cubs president Philip Wrigley in 1968. At the time, the Cubs were the only Major League Baseball team that didn't have lighting at its home field, Wrigley Field. The court refused to force Wrigley to install lights for night games, stating that "there must be fraud or a breach of good faith which directors are bound to exercise... in order to justify the courts entering into the internal affairs of corporations."
- AT&T provided communications services to the 1968 Democratic Convention and took no action to recover its $1.5 million bill. A group of shareholders sued, claiming that the action constituted an illegal campaign contribution on the part of the directors, as well as negligence in performing their directorial duties. The Third Circuit ruled in 1974 that AT&T's shareholders could get around the business judgment rule if they could prove the violation of the election law.
- After the bubble economy in Japan crashed in the late 1980s, Nomura Securities decided to compensate some of its heavyweight clients for their losses. Although a promise to do so in advance would have violated Japanese securities law, Nomura's executives claimed that this was a spur of the moment decision, and the evidence indicated that it was. The Tokyo District Court dismissed a suit brought by irate shareholders, holding that the compensation fell within the business judgment rule. (Japan's corporate law is very close to the United States'.)
The rule is now part of the Model Business Corporation Act, but remains common law in many states, including Delaware.