The Business Judgment Rule: the Director's Standard of Care
| Publication year | 1986 |
| Pages | 1809 |
1986, October, Pg. 1809. The Business Judgment Rule: The Director's Standard of Care
The exposure of directors of publicly and privately held corporations to potential liability has continued to expand as insurance coverage has continued to contract. From the directors' perspective the discouraging aspect is that, while the directors are required to make decisions in the heat of the moment without the luxury of protracted contemplation, their actions are judged by shareholders and courts after the fact. Courts in such situations attempt to view the decision from the point in time when the directors made the decision, but it is hard to imagine that they are unaware of subsequent events and subsequently discovered information.
Under Colorado law(fn1) and occasionally by contract, directors may look to the corporation to indemnify them for errors of judgment and omissions. However, effective January 1, 1986, directors seeking indemnification must meet a higher burden, and a corporation can no longer provide for indemnification beyond the statutory grant.(fn2) In addition, assuming the corporation has assets available from which to indemnify its directors, indemnification may be prohibited as against public policy.(fn3) Consequently, directors are more concerned than ever about potential liability and how to avoid it.
This article discusses the background of the new standard of care for directors and recent interpretations of the "business judgment rule" in various contexts. Suggestions are offered on how directors can comply with the established standards to insulate themselves from liability.
The Colorado Corporation Code contains the following statement of the duty that directors owe to the corporation they serve:
Nothing in the statutory mandate makes a director a guarantor that the decisions of the board in which he or she participates will be the best decisions. To the contrary, the statute recognizes human fallibility and the possibility that ordinarily prudent people may be wrongA director shall perform his duties as a director ... in good faith, in a manner he reasonably believes to be in the best interests of the corporation, and with such care as an ordinarily prudent person in a like position would use under similar circumstances.(fn4)
In what appears to be the first recitation of the business judgment rule by a Colorado court, in 1974 the Court of Appeals stated:
The good faith acts of directors of profit or non-profit corporations which are
within the powers of the corporation and within the exercise of an honest business judgment are valid. Courts will not ... interfere with or regulate the conduct of the directors in the reasonable and honest exercise of their judgment and duties.(fn5)
The Delaware Supreme Court recently has interpreted and reinterpreted the business judgment rule in a variety of contexts. The Court occasionally found the defendant directors liable because they did not act with the requisite care; the Court has also exonerated directors whom it found did act properly. In each case, the Delaware Court interpreted the business judgment rule under the Delaware statute defining the obligations of directors.(fn6) Although the Delaware statute interpreted by those courts is different from the Colorado statute, in light of the Delaware courts' interpretations, the difference appears to be one of form rather than substance.
As noted in "New Delaware Law," below, the Delaware legislature recently adopted an amendment to its general corporation law which enables Delaware corporations to adopt, subject to stockholder approval, a limitation on directors' liability. The following discussion reviews the standard applied in Delaware prior to the enactment and adoption of the new statutory standards by a Delaware corporation's stockholders. Since current Colorado law has no equivalent to the new Delaware law, it is likely that Colorado courts will continue to apply the business judgment rule.
The business judgment rule basically provides that courts defer to the judgments of the board of directors if the directors act in good faith, in a reasonably informed manner, and in a manner believed to be in the best interests of the corporation. As the Delaware Supreme Court said in Unocal Corp. v. Mesa Petroleum Co.:
be held to a higher standard than outside directors because of their greater familiarity with the company and, perhaps, the industry. It is also arguable that directors when acting on "ownership issues," should be held to a higher standard than when acting on "enterprise issues."(fn8) However, the real issue is not that of a higher standard but the extent of investigation the directors must make in order to act in an "informed manner." Significant decisions require greater care and more intensive investigation by the directors.. . . a judicial judgment will not be substituted for a board of directors' [informed] judgment if the board's decision can be attributed to any rational purpose.(fn7) It is arguable that inside directors should
In March 1985, the Delaware Supreme Court made a surprising decision in Smith v. Van Gorkom.(fn9) That case derived from the actions of the board of directors of Trans-Union Corp. in approving and completing a cash-out merger at a per share price approximately 50 percent greater than the market price of the Trans-Union stock. Before the merger was completed, certain shareholders brought an action...
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