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Key10 Mistakes or errors of judgment?

Directors make mistakes. They are permitted certain types and levels of mistakes under the legal principle called the business judgment rule. The business judgment rule means simply that courts will not substitute their business judgment ex post facto for the judgment of the board at the time it made its business decision. No judicial second-guessing of directors is permitted.

For example, in 1968, shareholders of the Chicago Cubs organization were sufficiently irritated to file suit against the Cubs’ board for its consistent refusal to allow night games at Wrigley Field. All other 19 teams in the National League at that time played night games. The shareholders argued that the board was passing up a lucrative source of revenues. The board responded that night games would increase the safety risk and threaten the character of the neighborhood and alter the tradition of the Cubs.

Under the liability limitation protections of the business judgment rule, the court ruled in favor of the Cubs’ directors. The board may have been wrong, the court said, but they did have their reasons for being wrong.

The business judgment rule does have some limitations in its protection. Slacker directors do not enjoy immunity: They are required to give the time and effort necessary to make a reasonable business judgment. If directors do their homework and attend meetings and make a mistake, the business judgment rule affords them protection. If they miss meetings and are not prepared and then make a mistake, they cannot invoke the business judgment rule. Courts are really quite testy when directors don’t do their homework and miss class, so to speak. If a director researches an issue, reads the materials, and attends meetings and still makes a mistake, there is protection. Directors who let other directors do their work by not attending meetings and by being an inactive board member will find themselves on the line when their colleagues make a bad business judgment.

Other types of conduct that will cost directors the protection of the business judgment rule include the failure to obtain outside advice on critical issues. For example, in a case in which the senior management of TransUnion Corporation had proposed a merger with another company the directors met only briefly, took management’s assertions, reports and data as fact and did not request any outside evaluation of the proposed merger. Based on a 20-minute oral presentation by the chairman, the directors approved the merger in less than two hours. The directors did not have an accurate figure on the per share value of the company. A shareholder filed suit and the court found the TransUnion directors could not invoke the business judgment rule because the premise of the rule is that the directors have made a reasoned, tempered and supportable decision. They can be wrong and not liable. But directors cannot be wrong and careless or precipitous and expect to escape liability.

For the protection from liability the business judgment rule provides, directors must:

• Attend meetings
• Prepare for meetings
• Obtain independent advice beyond management
• Deliberate carefully, often requiring more than one meeting for a decision