As human beings, we all have our strengths and limitations. We make mistakes, learn from them, and continue to grow. Most of us are ingrained with the aim for excellence, competence, and performing our best within the given circumstances.
Yet, in the context of work, mistakes can happen. Mistakes can be expensive and damaging in many ways, including financially, emotionally and reputationally. And not only that, but a workplace mistake often results in the loss of someone else's money. When a manager, officer or director of a company (referred to in this blog post as "management") makes a mistake, this can directly impact value to the underlying equity owners of the company.
So how does this align? Management generally owes fiduciary duties to the equity owners of the company. If an honest mistake is made which causes monetary loss to the equity owners, do the equity owners have recourse?
The Business Judgment Rule
Enter the legal theory known as the business judgment rule.
The business judgment rule is a legal principle which provides protection to management when making business decisions on behalf of the company. Under the business judgment rule, there is a presumption that the business decisions made by management are made in good faith, with due care, and in the best interests of the company. The rule recognizes that management is typically in the best position to make informed decisions, and that they should be given a certain degree of latitude and deference in their judgment and business decisions. Under the business judgment rule, management is provided with liability protection in many cases (though not all cases), even if their decision or action ended up being less than optimal for the company and its equity owners.
The business judgment rule reflects the notion that courts are generally reluctant to second-guess the decisions made by management unless there is evidence of fraud, self-dealing, bad faith, or breach of fiduciary duty. The rule is based on the idea that management should have the freedom to exercise its business judgment without undue interference from the courts. The presumption of good faith, however, can be rebutted in certain situations.
The details of the business judgment rule vary by jurisdiction. Generally, each state has its own statutes and case law on the topic. That said, in order for the business judgment rule to apply, the following key elements are typically required:
- Good Faith: The decisions made by management must be made honestly and without personal bias or conflicts of interest.
- Due Care: Management must exercise reasonable care, skill, and diligence in making decisions. Management should be adequately informed and should consider all relevant factors before reaching a decision.
- Rational Basis: The decisions made by management should have a rational basis and be within the range of reasonable alternatives. The rule does not require that the decision be the best possible choice, but rather that it is within a reasonable spectrum of options.
- Absence of Self-Interest: Management should not have a personal interest in the outcome of the decision that would compromise their ability to act in the best interests of the company and its equity owners.
If management meets the above criteria, courts will generally refrain from imposing liability on them for having made a mistake, for unfavorable outcomes or for losses resulting from management's decisions. Thus, the business judgment rule provides a degree of insulation (or "cover") for management, allowing management to make decisions in the best interests of the company without fear of being second-guessed or fear of unwarranted legal repercussions.
Its important to note that the business judgment rule is not an absolute shield against liability. The rule's presumption of good faith and fair dealing can be rebutted if its demonstrated that certain mis-deeds or incompetence occurred. As a result, it is wise for companies to periodically provide fiduciary duty training to their managers, officers and directors. Providing fiduciary duty training is good governance and is a smart way to help protect the management team and the equity owners and other company constituents. The greater the training and compliance with fiduciary duties, the greater the likelihood that the business judgment rule will be applied in a case of honest mistake. Moreover, when management is trained in fiduciary duties, they are more likely to follow the principals of good decision-making and corporate governance, and act in accordance with the best interests of their constituents.
The Law Office of Jennifer M. Settles advises companies on best practices in corporate governance, including fiduciary duty training.
Jennifer M. Settles, Esq. is a corporate lawyer at the Law Office of Jennifer M. Settles. She advises clients on corporate governance matters, M&A transactions, commercial contracts, real estate matters, financing transactions and more. To schedule a free consultation with Jennifer, please call 602-617-3938, or email us through the Contact Form on our website, www.jsettleslaw.com.