The phenomenal collapse of Enron Corporation, and the Senate hearings investigating the officers and directors of Enron, has brought to the forefront of the nation's conscience the question of liability of officers and directors for business decisions. Indeed, there are numerous lawsuits by shareholders of Enron Corporation against officers and directors, challenging their judgment. The potential for shareholder lawsuits challenging business decisions of officers and directors has implications not only for large corporations such as Enron, but any size corporation.
In order to limit shareholder derivative suits[1], the courts have developed the "business judgment rule", which insulates officers and directors from liability for corporate decisions if they are undertaken in good faith and in the best interests of the corporation. Accordingly, an understanding of the business judgment rule, and the procedural steps necessary to trigger its application, is crucial for an officer or director of a Pennsylvania corporation.
The Business Judgment Rule
The business judgment rule, as adopted in Pennsylvania, insulates an officer or director of a corporation from liability for a business decision made in "good faith". This rule is qualified by several requirements. For example, among other prerequisites, the officer or director must be adequately informed with respect to the subject matter of the business decision. Also, an officer or director must rationally believe that the business judgment is in the best interests of the corporation.[2]
The rationale for the business judgment rule is sound. Courts recognize that managers have both better information and better incentives than they. The business judgment rule "expresses a sensible policy of judicial noninterference with business decisions made in circumstances free from serious conflicts of interest between management, which makes the decisions, and the corporation's shareholders. Not only do businessmen know more about business than judges do, but competition in the product and labor markets and in the market for corporate control provides sufficient punishment for businessmen who commit more than their share of business mistakes."[3] Thus, shareholders challenging the wisdom of a business decision taken by management must overcome the presumptions inherent in the business judgment rule.[4]
In sum, the business judgment rule reflects a policy of judicial noninterference with business decisions of corporate managers, presuming that the managers pursue the best interests of their corporations, insulating such managers from second-guessing or liability for their business decisions in the absence of fraud or self-dealing or other misconduct or malfeasance.[5] This has been the policy of Pennsylvania for over a century, as reflected in the decisions of the Pennsylvania Supreme Court as early as 1872.[6] However, in order for the business judgment rule to be an effective means to avoid protracted litigation, corporate management must have in place and follow formal procedures, which insure the integrity of the business decision.
Procedures for Implementing the Business Judgment Rule
There are numerous factors which the Court will examine in order to determine whether a corporate decision warrants application of the business judgment rule. Factors bearing on the board's decision will include whether the board or its special litigation committee was disinterested, whether it was assisted by counsel, whether it prepared a written report, whether it was independent, whether it conducted an adequate investigation, and whether it rationally believed its decision was in the best interests of the corporation (i.e., acted in good faith). If all of these criteria are satisfied, the business judgment rule applies and the court should summarily dismiss the action.
Therefore, in order for the business judgment rule to be effective, prior to making any controversial or substantial business decision, such as responding to a demand by a shareholder to file a suit against a director or other party[7]; tender offers of corporate stock; termination of high-ranking corporate employees; major compensation increases; and purchase of subsidiaries or other major revenue distributions, the corporation must fulfill various procedural steps and document that its actions were taken in good faith and in the best interest of the corporation. These steps include maintaining thorough corporate records memorializing the details of the corporate decision, independent review of corporate decisions by counsel, and appointment of independent special committees. Documentation certifying that these steps were taken will be presented to the court to support the application of the business judgment rule and thus summary dismissal of a shareholder action.
Accordingly, corporate management should contact counsel to deal with these issues prior to any substantial corporate action, in order that steps may be taken to avoid costly and protracted litigation.
Should you have any questions regarding this matter or any commercial litigation issues, please call or e-mail John P. Corcoran, Jr. at (412) 261-6400 or jpc@jpcg.com.
