How does the Business Judgment Rule work?

The business judgment rule in section 180(2) of the Corporations Act relates to the director’s duties of care and diligence. It outlines the requirements a director or officer must fulfill when they make any judgment related to their business. They are to:

  1. Make the judgment in good faith or proper purpose
  2. Not have any personal interest in making that decision
  3. Make an informed decision
  4. Rationally believe that the judgment is in the best interest of the corporation. It must be a decision any other reasonable person in their shoes would make.

Essentially, the business judgment rule exists to protect directors. Directors have a requirement to act with care and diligence when exercising their powers. However, even if a director made the best possible decision for their company, it could always backfire. Section 180(2) exists to stop this from happening. It says that so long as a director meet the 4 requirements, they have acted with care and diligence. Therefore, the business judgment rule can defend a director or officer’s actions if they are accused of breaching the duty to act with care and diligence.

It also attempts to balance two competing aspects of running a business; that is to make sure a director isn’t being constantly questioned about their decision but also to make sure they are held accountable for their actions.

For the first 9 years since its introduction, the business judgment was rarely successfully raised. This is because there was (and still is to some extent) confusion how each requirement would be met.

Table of Contents

ASIC v Rich

The first time directors were able to successfully raise section 180(2) was in the 2009 case of ASIC v Rich. The case helped establish certain principles the business judgment rule operates on:

  • The onus of proof, that is the responsibility to prove they did not act without care or diligence, falls on the defendants.
  • A ‘Business Judgment’ also includes decisions:
    • made in preparing for a business decision
    • related to employees or other personnel, terminating litigation
    • setting goals
    • assigning responsibilities to the board or senior management
    • budgeting and forecasting
  • The requirement to make an informed decision is a requirement for the director to show they took actions to inform themselves rather than be aware of all the information. That is, actively trying to get access to information is more important than what you actually know.
  • The time and money restraints on making an informed decision are also important to consider
  • Rationality is not reasonableness. The court accepts a decision is rational if the director can explain how they got to it. It does not have to be the correct one, it just has to make sense based on what the director knew.

Further Developments

The decision in ASIC v Rich has its criticisms, primarily that it favors director’s authority over accountability. There aren’t however many cases that deal with s 180(2) and as a result, not much clarity on what circumstances attract the protection of the business judgment rule.

The 2015 case of ASIC v Mariner Corporations Ltd is another situation where the court held the director’s actions fell under the business judgment rule. In this case, ASIC alleged Mariner’s directors’ decisions to take over Austock was made without proper care or diligence. They alleged Mariner was not financially strong enough for takeover and did not secure any funding from the third party. However, in Court, Mariner’s directors were able to prove that:

  • They had a third party interested in buying Austock’s shares when Mariner’s acquired them and was therefore a smart business move
  • They had received extensive legal advice of the required level of funding and were able to arrange that amount
  • The directors were informed and convinced, after various meetings and discussions, that Mariner’s would benefit from the deal and any theoretical risks were minimal
  • The directors did not have any personal interest in the matter

Therefore the court applied the business judgment rule and found that the director’s had exercised the business decision with proper care and diligence

When does it not apply?

ASIC v Adler provides a great example of when directors cannot rely on the business judgment rule. In that case, three directors of HIH were accused of breaching several director’s duties by allowing HIH to illegally loan $10 million to PEE. The conduct that breached s 180(2) was where:

  • A director gained $10 million because the owned PEE and pocketed most of the loan for personal use
  • A director did not ensure proper safeguards were in place before authorising the transactions,
  • Another director did not present the company’s board or investment committee with a proposal to authorize a $10 million loan

Final Thoughts

There isn’t much litigation surrounding the business judgment rule and as a result, makes it hard to know when and how it will apply. There are still uncertainties and discrepancies amongst scholars about whether it has any use or not because it so rarely invoked. Therefore, it is always best if you speak to a business lawyer about any concerns you have about your duties as a director.

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