Under time-honored standards, and as developed over time by Delaware’s court, the business judgment rule is, as is often stated, a “presumption that in making a business decision, the directors of a company have acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the corporation.” However, as discussed in an interesting paper, in more recent times, courts have had to consider these principles in more troubling contexts, such as takeover battles or controlling shareholder transactions. As a result the courts have developed what BYU Law Professor D. Gordon Smith in his August 6, 2015 post on the CLS Blue Sky Blog (here) calls “the Modern Business Judgment Rule.” A longer version of Professor Smith’s paper can be found here.
The traditional business judgment rule applies when directors are reasonably informed about their decision, disinterested and independent, and acting in good faith. As applied by the Delaware courts, it operates as a procedural guide; if a plaintiff fails to show that the conditions for the application of the presumption have not been met, the rule operates as a substantive rule of law protecting the board’s decision from judicial review.
However, beginning in the 1980’s, Delaware’s courts began assigning the rule a more expansive role, particularly in cases involving takeovers. In these instances, the court held that the rule applied not only where all of the prerequisites for the rule’s application have been met, but also where the independence of the board of directors is potentially undermined by controlling shareholder or where the board of directors is financially interested in the transaction. As a result, Delaware’s courts have made what Professor Smith calls “innovative use of the business judgment rule,” in particular in cases involving takeover defenses, controlling stockholder transactions, and stockholder ratifications.
For example, with respect to takeover battles, the board of directors may face conflicts of interest due to their desire to maintain their positions and their duties to serve shareholders. In its 1985 decision Unocal Corp. v. Mesa Petroleum (here), the Delaware Supreme Court held that the business judgment rule may be available for the board in the context of a hostile takeover, but that the burden shifts to the defendants to show that the directors reasonably perceived a threat to the corporation and that the directors’ defensive responses were proportionate to the threat. The Court said that “Because of the omnipresent specter that a board may be acting primarily in its own interests, rather than those of the corporation and its shareholders, there is an enhanced duty which calls for a judicial examination at the threshold before the protections of the business judgment rule may be conferred.” If the directors are successful in carrying their burden under the two-prong Unocal standard, the court may confer the protections of the business judgment rule.
In the context of a controlling stockholder transaction, the board of directors also stands in a potential conflict of interest. Until recently, the Delaware courts have treated these transactions under the “entire fairness” standard, making the business judgment rule inapplicable. However, in the 2014 Delaware Supreme Court case Kahn v. M&F Worldwide Corp. (here), the Court identified conditions under which the protection of the business judgment rule may be available in these circumstances. The Court said the rule protection is available “if and only if” several conditions were met: (i) the controller conditions the approval of the transaction on the approval of both a special committee and a majority of the minority shareholders; (ii) the special committee is independent; (iii) the special committee is empowered to freely select its own advisors and to say no; (iv) the special committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority. If these conditions are satisfied, “the only avenue left to the plaintiffs is an argument of substantive irrationality.”
In both of the hostile takeover situation and the controlling stockholder transaction, the business judgment rule is available despite the presence of initial conflicts of interest, but only after a rigorous review of the processes involved. In each of these respective situations, Delaware’s courts have developed distinct paths to the protections of the business judgment rule. Upon reaching the rule’s protections, the result is the same; either, as in the case of Unocal, the plaintiff is left with no further arguments, or, as in the case of the controlling shareholder transaction, with “an insurmountable burden of showing that the board decision is substantively irrational.”
Thus in its application of the business judgment rule’s protections to these more problematic contexts, the modern business judgment rule “is not a one-size-fits-all doctrine, but rather a moveable boundary, marking the shifting line between judicial scrutiny and judicial deference.” The Delaware jurisprudence on the business judgment rule “reflects a general reluctance by Delaware courts to assume responsibility for the substance of business decisions.” Even in the more fraught contexts, the Delaware courts use the business judgment rule to “mark the point at which their responsibility for evaluating the decision ends.”