cl bjr

RESEARCH PROJECT ON

Business Judgment Rule SUBMITTED TO

CORPORATE LAWS II By

VISHNU. A.K.S. (Regd. No.BA0140077) SUBMITTED TO

Prof. Mr. Shankar Kaarmukilan

BUSINESS JUDGMENT RULE Objective

The researcher objective in this project is, 1. To understand the concept of business judgement rule. 2. To know about the business judgement rule in a comparative manner. 3. If the director is protected by business judgement rule as a shield?

Research Questions

What are the powers and duties of the directors of the company? What are the duties and liabilities of corporate directors; and second, what is the role of the  judiciary?

Research methodology

The study adopts qualitative approach, using comparative study design. The material used in the study include legislations, judicial decisions, books, electronic/ internet sources, journal articles. The study is principally an analysis and comparison of the legal provisions (both statutory and common law) relating to directors’ duty of care, skill and diligence. All conclusions are based on careful comparison between the corporate law in Australia and UK. Review of literature

The researcher has extensively relied upon articles referred, the books referred. The companies act explains the business judgement rule.

Tentative Chapterisation

CHAPTER I Introduction

CHAPTER II Business Judgment Rule i)Definition ii)Application iii)Scope

CHAPTER III Fiduciary Duties i)Duty of Care ii) Loyalty and Good Faith

CHAPTER IV Incorporation of the rule i)Australia ii)United Kingdom CHAPTER V Conclusion

CHAPTER I

Definition of Business Judgment Rule: The definition of the Business Judgment Rule is a difficult task. The reason why the rule is difficult to define precisely is that courts have used the term and applied it in so many different transactions that it is sometimes difficult to determine exactly how a court will apply it . In a given situation the rule is an effective protective devise. Business judgment means any decision to take or not take action in respect of a matter relevant to the business operations of the corporation.

CHAPTER II

Business Judgment Rule In American law, the business judgment rule finds its earliest expression in the United States in the first half of the 19th century.1  In a well-known decision, the Supreme Court of Louisiana decided to protect the managers in a business decision made in good faith and with no conflict of interests.4 According to the court’s view, it was irrelevant the result of the decision – that is, failure or success. Even though the rationale behind the implementation of this rule is quite similar, the way the business judgment rule has been implemented differs across jurisdictions. The moral hazard problem potentially generated by the use of the business judgment rule and the waiver of the duty of care is usually solved by requiring directors to make an informed business decision in the best interest of the corporation.2

1

Percy v Millauddon,1829  Thus, the directors are required to gather and assess information; and then, to make a decision in the best interest of the corporation based on this information. Therefore, if the decision is reviewed by a court, the focus should not  be the consequences of the decision but the process in which the decision was made. 2

Application of BJR:

The BJR is a broad protection and covers the vast majority of decisions that a director will encounter on a daily basis. However, the Rule, like all such protections, does have its limits. Embedded within the rule are a series of requirements and caveats that ensure that the rule will not be abused by directors and officers who act for the benefit of themselves or others and not for the benefit of the company and its shareholders. Consider the following as a partial list of the  prerequisites and subtext requirements of the rule, noting that the courts often expand this set when they feel, in their judgment, that a manager failed to act appropriately.

Exceeding the Scope of the BJR

In a general sense, there are only two possible outcomes when the scope of the BJR is exceeded. If a director acts in such a way that demonstrates a lack of prudence or potential fraud, and the company either does not suffer or actually benefits from the act, it is possible that no liability will result. Essentially, it is likely to be the case that if the director has acted rashly, perhaps even on a whim, and the company has made a profit from the otherwise inappropriate act, it is rare that a shareholder or government official will sue as no negative consequences have materialized. There is, however, a more likely scenario. In the event of such a loss, and without the protection of the BJR, the director or officer can face a variety of consequences, any combination of which the court may see fit to exercise. Typically, the court will do what it can to roll back the effects of the transaction, unwinding it where possible to return to the pre-transaction status quo. Absent that possibility, the court will likely have the director removed and award damages in the amount of any lost value to the company and, in an egregious case, punitive damages as well. Finally, any violation of the BJR that is in violation of a statute or court order can subject the director to

criminal liability and perhaps jail time for failing to act in compliance with the requirement of “best efforts” under the BJR.

What are the duties and liabilities of corporate directors; and second, what is the role of the  judiciary? The answer to the question, the role of the judiciary, depends upon whether the business  judgment rule is seen as a standard of director liability or an abstention doctrine. The former is the common understanding of the business judgment rule. It means that the standard of liability is usually gross negligence and that non-conflicted directors are shielded from liability for decisions made with good faith. The abstention doctrine contemplates that a judge will not rule on the substance of the directors’ business decision, but only examine the decision-making  process to determine that it was not compromised by conflicts, bad faith or inadequate information. The need to have an understandable business judgment rule that is applied predictably is critical to a country’s ability to attract investors in this global economy. The substance of any business  judgment rule will always be a function of each country’s legal structure and culture. The emphasis here is not on the substantive content of any country’s business judgment r ule but on a recognition that stability and predictability is important.

Delaware jurisdiction

The decisions of the Delaware courts are final and authoritative on almost all matters of corporate law in the United States because of the internal affairs doctrine. The internal affairs doctrine “recognizes that only one state should have the authority to regulate a corporation’s internal affairs the state of incorporation The fiduciary duties of directors of Delaware corporations are an equitable response to the power that is conferred upon directors as a matter of statutory law. Those equitable fiduciary duty  precepts date back to a decision by the Lord Chancellor of England in 1742. In Charitable Corp. v. Sutton, the Lord Chancellor explained that corporate directors were both agents and trustees

required to act with “fidelity and reasonable diligence.”3 Ever since the Suttondecision, courts have consistently stated that directors of corporations are fiduciaries who must comply with the duties of care described as reasonable diligence in the Sutton decision and loyalty described as fidelity in Sutton.4

CHAPTER III

Duty of Care

To receive the business judgment rule’s presumptive protection, directors must inform themselves of all material information and then act with care.In Delaware, the applicable standard of care is gross negligence.5 Interestingly, in the 1742 Sutton decision, the Lord Chancellor determined that the directors of the Charitable Corporation had failed to monitor the corporation’s loan procedures in making unsecured loans to directors. He held the directors liable for the resulting losses after concluding that their actions constituted gross negligence. The duty of care requires that directors inform themselves of all material information reasonably available before voting on a transaction. To become informed, a board can retain consultants or other advisors and can be protected by relying on statements, information and reports furnished  by those advisors, if their reliance is in good faith and the advisors were selected with reasonable care. The most significant duty of care case is the 1985 decision of Smith v. Van Gorkom. In that case, the Delaware Supreme Court held that the directors of Trans Union had breached their duty of care, because the board had failed to act on an informed basis.

3

Charitable Corp. v. Sutton, 2 Atk. 400, 406, 26 Eng. Rep. 642, 645 (Ch. 1742); see also Marcia M. McMurray, An

Historical Perspective on the Duty of Care, the Duty of Loyalty, and the Business Judgment Rule, 40 Vand. L. Rev. 605, 605 nn.1-2 (1987). 4

Constance Frisby Fain, Corporate Director and Officer Liability, 18 U. Ark. Little Rock L. Rev. 417, 419-20

(1996). 5

Smith v. Van Gorkom, 488 A.2d 858, 873 (Del. 1985).

Loyalty and Good Faith

In In re Walt Disney Co. Derivative Litigation, the Delaware Supreme Court held that grossly negligent conduct, without more, does not and cannot constitute a breach of the fiduciary duty to act in good faith. The Supreme Court acknowledged that conduct that is the subject of due care “may overlap with the conduct that comes within the rubric of good faith in a psychological sense, but from a legal standpoint those duties are and must remain quite distinct.” In Disney, the Supreme Court held that a failure to act in good faith may be shown (1) where the director intentionally acts with a purpose other than that of advancing the best interests of the corporation, (2) where the director acts with the intent to violate applicable positive law,, or (3) where the director intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his or her duties. In Stone, the Supreme Court stated: Although good faith may be described colloquially as part of a “triad” of fiduciary duties that includes the duties of care and loyalty, the obligation to act in good faith does not establish an independent fiduciary duty. The fiduciary duty of loyalty is not limited to cases involving a financial or other cognizable fiduciary conflict of interest. It also encompasses cases where the fiduciary fails to act in good faith. “A director cannot act loyally towards the corporation unless she acts in the good faith belief that her actions are in the corporation’s best interest.” In Stone, consistent with its opinion in Disney, the Delaware Supreme Court held that Caremark articulated the two “necessary conditions for assessing director oversight liability”:  (1) the directors utterly failed to implement any reporting or information system or controls or (2) having implemented such a system or controls, the directors consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or  problems requiring their attention.

CHAPTER IV Incorporation of the rule Due to the major collapse and failure of few in Australia in 80’s Australia was going through a development phase. The duties of care and skill i.e. fiduciary duty of the director’s where under examination and these were strengthen by adopting an objective standard 1) Australia Section 180 of the Corporations Act of 2001 of Australia provides for the duty of care, skill and diligence; “A director or other officer of a corporation must exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise if they: (a) Were a director or officer of a corporation in the corporation’s circumstances: and (b) Occupied the office held by, and had the same responsibilities within the corporation as, the director or officer. In Australia, the original subjective test for the duty of care has been replaced with an objective standard both at common law and statute law. In AWA case (Daniels v. Anderson) the court considered the four major aspects of duty of care: the nature of the duty, the ability for directors to delegate, the need for directors to keep informed about the company’s business, and the standard of care for both executive and non-executive directors. Clarke and Sheller JJA recognised that directors can and should have ‘varied commercial backgrounds’; but irrespective of the background they have a ‘duty greater than that of simply representing a particular field of experience.’ Further, the contention that nonexecutive directors ought to be able to rely on a low standard and one of more subjective nature was also rejected by the NSW Appeal Court. It was emphasised that objective duty of care apply to both executive and non-executive directors. In the case of ASIC v. Healey the Australian Federal Court of Appeal held that directors of a company were liable for a breach of their duty of care and diligence by not noticing that the company’s financial records incorrectly classified a large number of current liabilities as noncurrent liabilities. Middleton J held that “the directors failed to take all reasonable steps required of them, and acted in the performance of their duties as directors without exercising the degree of care and diligence the law requires from them.” The case highlights the importance of directors

making ‘informed decisions’ and the need to apply themselves diligently and with an inquiring mind so that they can form their own opinions. The view of the Australian judiciary is that what is in the best interest of the company should be decided by the directors of the companies.

2) United Kingdom The UK was one of the first nations to establish rules governing the operation of companies. Over several centuries UK has had a host of legislations relating to companies. However, these statues did not contain a detailed provision describing the fiduciary duty of directors until the Companies Act of 2006 was enacted. The common law concept of fiduciary duty of directors on the other hand was developed by the UK courts through numerous cases. Section 174 of the Companies Act of 2006 provides “A director of a company must exercise reasonable care, skill and diligence. This means the care, skill and diligence that would be exercised by a reasonably diligent person with the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company, and he general knowledge, skill and experience that the director has.” Australia, business judgment rule is not provided in the UK Companies Act. However, it is taken up by courts. Like the Australian Courts, the courts in UK now appreciate there is a distinction between oversight and management which means the nature and extent of the duty of skill, care and diligence will depend on factors such as the size, location and complexity of a company’s business and urgency of any decision. The formulations in section 174 take account of the special background, qualifications and management responsibilities of a particular director.” Alternative The rule doesn’t need any codification the rule could best address to its purpose if it’s implied by the court and the courts follow a lenient approach towards the decision of the company directors. however the only argument which could support it is the amount of second guessing judiciary does in the application of the rule hence it could be said that rule as it stands is nothing but a encourages director with extra security, which even without this rule shall protect the director

who follow their duties honestly in good faith sand for the best interest of the corporation.

CHAPTER V:

Conclusion Australia and UK differ in many way, the Australian legislature is more active hence in time if the rule stands out to kill the very purpose of the adoption, the modification shall be brought about, certainly this is not the case with U.K. certainly the introduction of rule has evolved and helped Australian director’s to come out of the confusion which they faced in respect of their duties. However clearer the position it is not a safe harbor, the only wise approach is honestly. As in criminal law assertion is ignorance of law is no excuse similarly for directors in relation to their duties it could be said ignorance of duties is no excuse. Hence rule aims at eradicating the fear of the personal liability of director, however thinking of a situation where the action is  brought and the judiciary analyzing the details of the decision taken in the light of four conditions doesnot seem to be a viable idea because sometimes the decision are taken by individuals depending upon their nature that might be for the interest of the corporation and might be not and every decision is not wrong or right there are grey areas, hence the rule does not speak about those grey areas and generally the protection should be afforded in those cases The nature of duties of director may demand the presence of a business judgment rule however in the light of the above present arguments it would not be wrong to say that the purpose of the rule has been suppressed keeping in mind the extra synthesis of the decision of a corporate by the court. the starting place of the rule U.S has seen over the years that rule creates more problem than it solves it exemplifies itself with the raised premiums and finally a change for the no liability clause in the constitution of the company, one should not forget that even with regard to  business judgment rule the court can be very detailed and strict about applying the conditions to  be met in BJR. Hence it s evident that rule does not stands as effective a cover for the directors as it appears to be on the onset. The purpose of the rule is a protection against liability only if the four conditions are met, however one does not realize the fact that in evaluating these conditions the fiduciary duties

which without the rule would have been evaluated. The law is moving towards expecting an objective test of care, skill and diligence from both executive and non-executive directors. The standard expected in decision making of a director is what is reasonably required of a person having the knowledge and skill and experience required in that position. Sri Lanka needs to develop its approach to duty of care to reflect an appropriate balance between protections on interests of shareholders on the one hand and promotion of entrepreneurial endeavours on the other. Such a balance will boost the corporate financial success. They can prepare and take  precaution for the challenge head of them.