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San Diego Law: What is the Business Judgment Rule? (Part I)

The business judgment rule provides personal immunity to directors of a corporation from being sued by the shareholders and/or investors if a decision made by the directors turns out to be a bad one. The business judgment rule is another way in which the corporate entity shields the personal assets of those involved in running the company.

There are two variants of the rule – one that shields the directors from personal liability and one that shields the corporation itself from being sued in a shareholder derivative action. This article discusses the first variant. The second variant will be discussed in a later article.

Shielding Directors from Personal Liability

The first variant of the business judgment rule is statutory and, as said, immunizes corporate directors from personal liability if they act in accordance with the business judgment rule. See Cal. Corp. Code § 309. A version of the business judgment rule is also codified for nonprofit corporations. See Cal. Corp. Code § 7231.

The business judgment rule requires that a director:

“perform the duties of a director, including duties as a member of any committee of the board upon which the director may serve, in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances.”

If a director complies with the business judgment rule, then he or she is shielded from liability based upon any alleged failure to discharge the person’s obligations as a director. This means that, even if a decision turns out to be disastrous financially for the corporation, the director cannot be held personally liable by the shareholders and investors.

On What Information can a Director Rely?

In addition to setting out the business judgment rule, the statute sets out certain categories of information on which a director can rely in making decisions for the corporation. The types of information listed are:

  • Information from officers or employees of the corporation whom the director believes to be reliable and competent in the matters presented
  • Information from legal counsel, independent accountants or other persons as to matters which the director believes to be within such person’s professional or expert competence
  • Information from a committee of the board upon which the director does not serve, as to matters within its designated authority, which committee the director believes to merit confidence

This is important because it avoids litigation and lawsuits over alleged failures to investigate and failure to fully investigate. The statute DOES impose an obligation to make “reasonable inquiry when the need therefor is indicated by the circumstances …” but such “circumstances” are rare.

What are the Exemptions from the Business Judgment Rule?

In general, there are three ways that a director can be found to have violated the business judgment rule:

  • Fraud (sometimes called “bad faith”): Director commits actual fraud or purposefully hides information from the corporation and/or the other members of the board
  • Recklessness: A director that knowingly ignores or purposely avoids adverse information that would have impacted a decision can be deemed to have acted with reckless disregard for financial risks
  • Breach of loyalty: The most common exception is where a director usurps or diverts corporate opportunities to him or herself

Interplay of the Business Judgment Rule with Directors and Officers Liability Insurance

The business judgment rule does not prevent a director from being sued and, as such, it is not a substitute for purchasing Directors and Officers liability insurance. Litigation is expensive and the insurance will cover those costs.

Contact San Diego Corporation Law Today

If you would like more information about the business judgment rule and other aspects of running a corporation, contact attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard proudly serves the San Diego area, offering a full range of legal services to his business clients. Mr. Leonard can be reached at (858) 483-9200 or via email.

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