The Business Judgment Rule: Hardcore Protection for Officers and Directors.

When a director or an officer makes a decision on behalf of the credit union, there is always the chance that the decision will later be second-guessed.  Suppose, for example, that the credit union decides to change data processors and the new vendor does not perform.  Who gets the blame?  Another example might be the decision to start a new line of business at a credit union by partnering with a vendor in the sub-prime lending arena.  If the vendor and the credit union lose money together, who is blamed for the decision?  What are the consequences?  What defense does a director or officer have if he or she is sued as a result of a decision made?

The common law has an answer in the Business Judgment Rule (“BJR”).  Some states have codified this.  In other words, in some states, it is a law on the books that a director can review.  One leading case has defined the BJR as:

A presumption that in making a business decision, the directors of a corporation acted on an informed basis in good faith and in the honest belief that the action was taken in the best interests of the company.  Aronson v. Lewis 473 A.2d 805, 812 (Del. 1984).

Making a decision on an informed basis means doing your homework.  There is a threshold level of due diligence required.  A director can rely on reports and opinions from professionals to achieve this.  Going back to the vendor contract example, a Board could rely on a memorandum from the CEO describing how the CEO took bids from three vendors and how he or she came to recommend one of the three.  The Board can rely on attorney opinion letters regarding the vendor contract as well as an accountant’s opinion as to the financial status of the vendor.  The point is that the Board does not have to go at it alone.  Indeed, reading reports and using outside opinions helps a Board show that it has made decisions on an informed basis.

Lack of self-interest is another key element.  When I give presentations on director and officer liability, I cannot stress enough how bad it is to be self-serving.  Let me make it clear here:  if you will benefit personally by a decision that you make as a director, you will lose the protection of the Business Judgment Rule.  There is a presumption that a director who acts on behalf of a credit union with his or her own interests involved does not act in good faith.

Generally speaking, when reviewing a decision made by a director or officer, the

[C]ourt will examine the decision only to the extent necessary to determine whether the plaintiff has alleged and proven facts that overcome the business judgment rule presumption that business decisions are made by disinterested and independent directors on an informed basis and with a good faith belief that the decisions  will serve the best interests of the corporation.  1 Dennis J. Block, Nancy E. Barton, Stephen A. Radin, The Business Judgment Rule Fiduciary Duties of Corporate Officers at 5 (1998)

This is a good idea.  We want directors and officers to be able to make decisions on an informed basis, without self-dealing, quickly and efficiently.  We don’t want officers and directors to constantly second-guess decisions.  Moreover, it’s only fair.  As one court stated:

The contrary doctrine seems to us to suppose the possession, and require the exercise of perfect wisdom in fallible beings.  No man would undertake to render a service to another on such severe conditions.  Percy v. Millaudon 8 Mart. (n.s.) 68 (La. 1829).

So we protect officers and directors to an extent.  Another court put it this way:  “The business outcome of an investment project that is unaffected by director self-interest or bad faith cannot itself be an occasion for director liability.  That is the hard core of the business judgment doctrine.”  Gagliardi v. TriFoods Int’l, Inc. 683 A.2d 1049, 1051 (1996). 

However, the defense is not ironclad.  There have been instances where a court has allowed plaintiffs to second guess the directors.  In Litwin v. Allen, 25 N.Y.S.2d 667 (Sup. Ct. 1940), a Board bought debentures for three million dollars.  Unfortunately, the purchase agreement allowed the seller to buy back the debentures at their sale price within six months.  Thus, if the debentures lost money, the company bore the loss.  If the debentures made money, the seller would realize the gain.  It really amounted to a case of negligence on the part of the Board.  In Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), the directors of a company sold their company after hearing a 20-minute presentation and failed to read the merger agreement or conduct due diligence on the sale price.  To the court, it was a gross example of the Board not doing its homework.

In short, a Board is entitled to rely on outside opinions:  accountants, lawyers, auditors, etc.  A Board is protected when it makes a decision in good faith without self-interest.  If a board does its due diligence but makes a bad decision, the BJR offers the Board protection if things don’t go as planned.