Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master's in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.
Updated April 27, 2022The Business Judgment Rule is a legal doctrine that helps to guard a corporation's board of directors (B of D) against frivolous legal allegations about the way it conducts business. A legal staple in common law countries, the rule states that boards are presumed to act in "good faith"—that is, within the fiduciary standards of loyalty, prudence, and care directors owe to stakeholders. Absent evidence that the board has blatantly violated some rule of conduct, the courts will not review or question its decisions.
Fiduciary standards include the "duty of care" and the "duty of loyalty." The first is an obligation to act on an informed basis. The second requires directors to put the interests of the corporation and over their own self-interest or the interests of others.
The business judgment rule acknowledges that the daily operation of a business, as well as its long-term strategy, requires making controversial decisions or taking actions that put the company at risk. All business decisions are to some extent risky, whether they involve starting a new line of business or buying another company. Generally speaking, higher profits require taking greater risks.
The principle underlying the rule is that the B of D should be allowed to make such decisions without fear of prosecution by shareholders who might object. The rule assumes that it is unreasonable to expect managers to make optimal decisions all the time. As long as a court believes that directors are acting rationally and in good faith, it will take no action against them.
The Business Judgment Rule is a judicial doctrine arising from United States Courts' respect for corporate self-governance. This doctrine creates a presumption of good faith business judgments of corporate management, and shifts the burden to the accuser to demonstrate that a decision at issue falls into any of the below limits and exceptions.
There are certain instances in which director decisions can end up in the courts. For example, a director sells a company asset to a family member for an unjustifiably low price. This would be an example of self-dealing that the rule would not insulate from prosecution.
In order to challenge the presumption that is the heart of the rule, plaintiffs must show evidence that directors have acted in bad faith. This might include engaging in fraud, committing a breach of trust or creating a conflict of interest, abdicating corporate responsibility, or failing to investigate unethical corporate behavior that is obvious when committed.
The Rule thus does not apply in cases where the board of directors:
The sixth is the most common form of attack under the Rule, as shareholders can argue that the board has made a decision where they remained uninformed.
Say that XYZ Company's board is considering shutting down a particular product line. Profit margins on the product have been shrinking and the product is becoming extremely costly and eating into revenues from other business lines.
The board decides that discontinuing the product would free up resources necessary to focus on more profitable areas. In this case, the business judgment rule protects directors from prosecution by shareholders who disagree with their decision or who are adversely affected by it.