October 8, 2008

The Business Judgment Rule – a pragmatic solution to a pretty problem

Filed under: Corporate governance — Nicola Rowe @ 3:01 pm

Shrinking back from the legal liability taking up a directorship will involve? Relax. Courts in English-speaking countries have repeatedly refused to look at decisions taken by directors when exercising business judgment. The High Court of Australia put it nicely forty years ago in Harlowes Nominees Pty Ltd. v Woodside:

Directors … may be concerned with a wide range of practical considerations, their judgment, if exercised in good faith and not for irrelevant purposes, is not open to review in the courts.

In other words, creditors and shareholders looking to recover from directors for losses resulting from poor business decisions will be disappointed to know that those decisions are not subject to review by the courts. It’s a massive exemption from liability, and it’s not one enjoyed by doctors, dentists or – until relatively recently, in most Commonwealth countries – even lawyers themselves. So why grant directors such freedom to mess up?

Delve deeply enough into the literature, and you’ll find as many justifications for the rule as you care to name. But there are three central reasons. First, scholars argue that people otherwise qualified to serve as directors won’t do so if their decisions are constantly second-guessed. This is well and good – no one likes to be constantly second-guessed, after all – but it’s not a reason to exempt a person from legal liability. Remember that we’re all responsible for reasonably foreseeable harm caused to others as we go about our daily business. Why should directors – who owe shareholders a fiduciary responsibility beyond what we owe each other in everyday social interaction – be held to a lesser standard than the rest of us?

Secondly, it’s said that courts are not equipped by nature to examine business decisions, and couldn’t act in real time even if they were. But, while it’s true that judges aren’t businesspeople, they’re not architects or forensic psychiatrists, either. That’s why courts call expert witnesses. There’s no reason experienced directors couldn’t be called on to testify about the wisdom of business decisions. And, true, the wheels of justice grind slowly – much more slowly than the wheels of commerce. But most allegations of director misconduct are made after the fact, in the context of an action for damages in the aftermath of bankruptcy, where time is no longer an issue. The courts have mechanisms for acting swiftly – injunctions are frequently granted under urgency – and there’s no reason they couldn’t deliver emergency interim relief in the same way.

The third and final reason given for the business judgment rule is that business requires risk-taking, sometimes even to the point of speculation, and that the directors are free to do just that. The argument here isn’t that, being in a position of responsibility, they should be held to a stricter standard than the rest of us; rather, it’s the reverse. Are the directors spending shareholders’ money irresponsibly on too risky ventures? Then, on this view, it’s up to the shareholders to fire them. Have the directors overcommitted themselves (without going as far as trading recklessly)? Caveat supplier – the firm’s trading partners should have done their due diligence before going into business with them.

Who watches the watchers? The business judgment rule says no one does, as long as the directors are using their powers for proper purposes to make good faith decisions. Why? Logically, the only reason is risk: it’s necessary for business, and someone – in this case, the directors – is allowed to take a lot of it.



  1. Great blog! I love your writing.

    It prompted a frivolous thought for this Friday afternoon. How many books and movies have been made with a business theme, versus the number with a medical and legal slant? (The Gordon-Gecko-greed-is-good movie is the only one I can think of). I think it’s because doctors and lawyers have power to confer, ultimately, life or death, and we are compelled by the drama. It fascinates us and we want to control it. The law, then, provides a framework for that control.

    The loss of life triggers truly visceral fear, the loss of a nestegg less so. Therefore directors can get away with stupidity (and even cupidity), but doctors can’t.

    Comment by SWS — October 10, 2008 @ 2:06 pm

  2. No, indeed! Asking around reveals nothing more business-related than 1998 rom-com You’ve Got Mail, in which big-business bogeyman Tom Hanks puts independent bookshop owner Meg Ryan out of work. And, even then, it’s really all about email.

    It’s odd, because people’s feelings *are* bound up in business – we don’t leave our emotions behind when we come to work, and business can be quite as fascinating as medicine or the law, as the success of 60s reprise show Mad Men makes clear.

    Perhaps it’s time for us to join the Screenwriters’ Guild and put things right?

    Comment by Nicola Rowe — October 12, 2008 @ 7:22 pm

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