Is Your Board Protected by the Business Judgment Rule?

By: Danielle Palardy – Published in the BizWest Thought Leaders column in December 2021

Closely held corporations and small businesses in Northern Colorado are often built on close relationships, which unfortunately sometimes go south. When this happens, there may be disagreements on business transactions, monetary distributions, or other corporate decisions, which may lead to litigation. A board of director’s decisions are presumed to be protected by the “business judgment rule” – the concept that a corporate director is shielded from liability so long as the director’s decision was made in good faith, with reasonable care, and with the reasonable belief that the action is in the best interests of the corporation. A director’s decision will not be protected if there is evidence of gross negligence, bad faith, or if the director had a conflict of interest.

Conflicts of interest are quite common within closely held and small businesses. A few examples will help explain. If a company wishes to purchase real property, and the seller is a close relative of a director, there is a conflict of interest because the director’s decision is biased by the fact that the seller is family. If a company is purchasing supplies, and a director is a shareholder or owner of the supplier, the director is biased because the director stands to benefit financially from the transaction with that supplier.

There are certain steps a company can take to ensure the business judgment rule will protect its board of directors. Consider what screening processes, voting processes, or notice processes the company has in place to detect a conflict of interest, ensure that the decision is made without influence of that conflict, and ensure transparency with its shareholders. By researching the transaction and assessing possible conflicts, the board can demonstrate that its action was informed with respect to conflicts. If the board has multiple directors, a vote of a majority disinterested directors would show that the action was not influenced by the interested director. If the board includes a notice to shareholders of transactions it is considering which involve a conflict of interest, the board will be less likely to be surprised by shareholder malcontent and may protect itself from future suit on the grounds that shareholders had notice of the transaction. Consider whether your bylaws include a process for shareholders to notify the board of a conflict of interest concern prior to commencing a lawsuit as a result of the conflict of interest.

A transaction or other corporate action might be in the best interest of the company even if there is a conflict of interest, and the existence of a conflict should not be an automatic bar on taking the action – however, by taking some of these steps, a company can reduce the risk of litigation from unhappy shareholders and can protect its board of directors, which will reduce disruptions to operations and cost to the company.

Different solutions are appropriate for companies of different sizes and in different industries. Consider the above options for your company and engage an attorney to assist you with implementing procedures to suit your business.

Danielle Palardy