§ 3.05 The Business Judgment Rule

• Jurisdiction: Washington

§ 3.05 THE BUSINESS JUDGMENT RULE

[1] Overview

The business judgment rule is a standard for the judicial review of conduct by corporate directors and officers. See Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914, 927 (Del. 2003) ("The business judgment rule, as a standard of judicial review, is a common-law recognition of the statutory authority to manage a corporation that is vested in the board of directors." (quoting MM Cos. v. Liquid Audio, Inc., 813 A.2d 1118, 1127 (Del. 2003))). The business judgment rule plays an important role in derivative litigation. The business judgment rule often provides directors and officers with a defense at the pleading stage to claims that they breached their duties to the corporation with respect to specific board actions and decisions, most notably decisions involving corporate mergers and acquisitions. See, e.g., Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1994) ("If a shareholder plaintiff fails to meet [the evidentiary burden to rebut the business judgment rule], 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."). But the rule may also come into play in evaluating how a corporation responds to shareholder demands or derivative lawsuits. For instance, the rule provides the standard of review for evaluating a board's decision to refuse a shareholder's pre-litigation demand. See § 3.03[1][d]. The business judgment rule may also play a role in judicial review of a special litigation committee's motion to terminate a derivative lawsuit. See § 3.03[1][g].

[2] The Governing Standard

Under the business judgment rule, as it is applied in Washington, "corporate management is immunized from liability in a corporate transaction where (1) the decision to undertake the transaction is within the power of the corporation and the authority of management, and (2) there is a reasonable basis to indicate that the transaction was made in good faith." Scott v. Trans-System, Inc., 148 Wn.2d 701, 709, 64 P.3d 1 (2003) (citing Nursing Home Bldg. Corp. v. DeHart, 13 Wn. App. 489, 498, 535 P.2d 137 (1975)). Reasonableness requires "a director [to] also act with such care as a reasonably prudent person in a like position would use under similar circumstances." Riss v. Angel, 131 Wn.2d 612, 633, 934 P.2d 669 (1997). Thus, "a [Washington] court will not substitute its judgment for that of corporate directors '[u]nless there is evidence of fraud, dishonesty, or incompetence (i.e., failure to exercise proper care, skill, and diligence' [.]" Id. at 632 (quoting In re Spokane Concrete Prods., Inc., 126 Wn.2d 269, 279, 892 P.2d 98 (1995)); accord Garret v. Materia Grp. LLC, No. 2:19-cv-1129, 2021 U.S. Dist. LEXIS 35746, at *16 (W.D. Wash. Feb. 25, 2021) (applying business judgment rule absent evidence that transaction at issue was the result of "fraud, dishonesty, or incompetence").

If directors or officers are sued based on a particular decision, the court will examine that decision to determine whether the plaintiff has alleged particularized facts sufficient to rebut the presumption that the directors or officers are protected by the business judgment rule. Because Washington courts review corporate business decisions consistent with the tenets of the business judgment rule, they infrequently reverse business decisions. See Lane v. City of Seattle, 164 Wn.2d 875, 882, 194 P.3d 977 (2008) (contrasting deferential standard of review under business judgment rule with less deferential standard applicable to government actions and stating "we . . . infrequently reverse a business decision").

In cases where the presumption that the business judgment rule applies to protect corporate action is not overcome, the business judgment rule precludes the court from post hoc examination of the merits of the decision in question. But where the presumption is overcome, the responsible directors and officers may bear a higher burden of proof, under either the "entire fairness" standard, Kunkle v. W. Wireless Corp., Nos. 55067-5-I, 55164-7-I, 2006 Wash. App. LEXIS 1283, at *16 (Wash. Ct. App. June 19, 2006) (unpublished) (citing Cede & Co., 634 A.2d at 361), review denied, 161 Wn.2d 1010 (2007); see § 3.05[7] (discussing "entire fairness" standard ofreview), or the "enhanced scrutiny" standard, In re McDonald's Corp. S'holder Deriv. Litig., 291 A.3d 652, 686 (Del. Ch. 2023). The difference between these levels of judicial scrutiny of corporate decisions can be outcome-determinative. For instance, a decision that would not survive scrutiny under the entire fairness standard may never receive such scrutiny if the plaintiff does not overcome the business judgment rule presumption.

[3] Rationales for Application of Business Judgment Rule

There are several rationales for the application of the business judgment rule. First, corporate decision-making involves risk, and courts recognize that even independent and disinterested directors can make good-faith decisions that, assessed with the benefit of hindsight, were improvident or caused losses to the corporation. See In re Citigroup Inc. S'holder Deriv. Litig., 964 A.2d 106, 126 (Del. Ch. 2009) ("To impose liability on directors for making a 'wrong' business decision would cripple their ability to earn returns for investors by taking business risks. Indeed, this kind of judicial second-guessing is what the business judgment rule was designed to prevent . . . ."); see also DeHart, 13 Wn. App. at 498-99 ("[D]irectors of a commercial...