BY JENNIFER LYNN PETERS, ESQ.
As the economy plunged and debtors looked for ways to avoid paying their obligations to lenders across the country, the courts saw an explosion of cases alleging breach of fiduciary duty, breach of the duty of good faith and fair dealing, and other “mismanagement” by directors, officers, and/or managers of financial institutions and other entities. A growing number of such claims by shareholders and others affected by the closure of a financial institution are also being filed. So what is a director, officer, or manager to do when faced with such claims? Often, the legal doctrine known as the Business Judgment Rule can provide the best, most effective, and first line of defense.
The Business Judgment Rule is a legal presumption that provides that so long as a director or officer of a company is disinterested, has acted on an informed basis, in good faith, and with an honest belief that the action taken was in the best interests of the company, the decisions made are not subject to challenge. In adopting the Business Judgment Rule, the Colorado Supreme Court described it as follows: the “business judgment doctrine bars judicial inquiry into the actions of [a manager] taken in good faith and in the exercise of honest judgment in furtherance of a lawful and legitimate corporate purpose.” Hirsch v. Jones Intercable, Inc., 984 P.2d 629 (Colo. 1999). When the Business Judgment Rule applies, decisions and actions of disinterested directors and officers will not be disturbed or questioned by a court if they can be attributed to “any rational business purpose.” Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984). The rule is meant to preclude a court from imposing its own judgment on the business and affairs of a company.
In order to demonstrate that the Business Judgment Rule applies, an officer, director, or manager must generally show three things. First, it must be shown that the officer, director, or manager is independent or disinterested. This typically involves a review of the financial interests of the officer, director, or manager whose actions are being challenged to show she did not have a financial interest in the underlying transaction. Second, it must be shown that the decision being challenged was made in good faith. This usually involves a simple showing that there was a reason for the decision or action and what the stated motivation for the decision or action was. Third, it must be shown that the decision or action was “informed” or exercised with “due care.” This typically requires some evidence that there was a reasonable effort to ascertain and consider all relevant information prior to the decision being made or action being taken.
It is important to keep in mind that the Business Judgment Rule does not apply where a director, officer, or manager being sued is shown to have an interest, usually a financial stake of some sort, in the transaction in dispute. A director, officer, or manager is not “disinterested” if they either stand on both sides of a transaction or expect to derive a personal financial benefit from it. In other words, if the director, officer, or manager is engaged in self-dealing, she cannot claim the benefit of the Business Judgment Rule as a defense to claims of mismanagement. However, self-interest alone is not sufficient to disqualify an officer, director, or manager from using the Business Judgment Rule as a defense. Merely alleging complete dominion or control over business decisions is also not enough to defeat the Business Judgment Rule. There must be evidence that there was disloyalty to the organization, and that the benefit received was material or significant, rather than minimal. Thus, where it is shown by some tangible evidence that a director, officer, or manager either received or could have received a direct and substantial benefit from the transaction, the Business Judgment Rule will not be available as a defense.
Under the Business Judgment Rule, the mere fact that, in hindsight, an officer, director, manager, or management group made a bad decision or a mistake is not sufficient to challenge that decision or allege breach of fiduciary duty or other mismanagement claims. Courts acknowledge that, while shareholders might disagree with a management decision, and while it may be apparent in hindsight that the decision was wrong, the decision can withstand an attack because it was made in good faith by disinterested persons. In the absence of fraud or bad faith, the Business Judgment Rule thus often provides a complete defense to rising claims of breach of fiduciary or other obligations being levied against directors, officers, and managers.
This article was published in the September/October 2011 edition of The Independent Report, the official newsletter of the Independent Bankers of Colorado and the June 2012 edition of the Colorado Bar Association Business Law Section Newsletter.