Business Judgment Rule
by Markus Roth
1. Introduction
The business judgment rule provides a safe harbour for the directors concerning liability for violations of the duty of care. Protected are the members of the board of directors in the one-tier board and the members of the management and the supervisory board in the two-tier board. The German business judgment rule for members of the management and the supervisory board, introduced in 2005, is based on the US model. The German model of the business judgment rule also influenced the codifications in Romania and Liechtenstein; a similar provision is provided by the Portuguese Commercial Company Act, Art 71(2). Even if not codified, the business judgment rule is also applicable elsewhere in Europe. In Switzerland, the business judgment rule is applied, and its codification is being considered. France and England also recognize a safe harbour from liability for the directors. There are numerous arguments for granting this safe harbour from liability: the danger of a judicial determination on the results of a business decision made at a time of uncertainty (hindsight bias), the greater expertise of the company directors in relation to judges, the related principle of judicial self-restraint, encouraging capable persons to assume the position of director, the efficiency of shielding ‘honest decisions’ from judicial review, the protection of risky decisions with the opportunities of high returns, the need to decide under time pressure and the protection of the internal organization of the company’s management. Apart from the protection of the acting board members, the directors’ safe harbour from liability corresponds with the interests of shareholders and provides sufficient entrepreneurial freedom for corporations. These arguments are also accepted in countries of the European Union, such as the United Kingdom, which have not codified the business judgment rule.
2. Legal environment
The considerations mentioned above justify a safe harbour for members of the supervisory board and management board if certain requirements are met. The business judgment rule applies only when there is no breach of fiduciary duties and no violation of law, company statute or of the decisions of the annual meeting or the supervisory board. Also, corporate directors with conflicts of interests are not protected by the business judgment rule. These generally accepted principles are applied in the United States due to the particular jurisdiction of the Delaware courts and in many European countries due to the non-recognition of business discretion in these instances. In Germany, the business decision is, according to many scholars, the doctrinal basis for the business judgment rule’s non-recognition of violations of directors’ fiduciary duties or the law. In autonomous interpretations of the German business judgment rule, the business decision is even seen as the most important precondition for the German business judgment rule.
The business judgment rule protects, in particular, the business discretion of the board members of a corporation. Business discretion is the overall concept accepted by all jurisdictions, including those without a codified business judgment rule, and even by jurisdictions that refuse to adopt an explicit business judgment rule into national company law. In Germany, the concept of the business decision is applied by the Federal Supreme Court (BGH) even after the codification of the German business judgment rule (BGH 3 March 2008 [2008] NZG 389, 390). In general, the standard of review is the same for business discretion and business judgments. Exceptionally, a more stringent test applies to actions of the board. This is especially the case for acts of the management board and the supervisory board, which may only in a broader sense be treated as business judgments. Only limited business discretion is considered to exist if statutory provisions leave room for estimations of future developments or the appropriateness of decisions. In Germany, the decision of the management and the supervisory board must be reasonable where exercising the business discretion to utilize authorized capital under exclusion of subscription rights. The same applies to the liability for delaying insolvency proceedings and for accounting decisions which leave room for valuations and decisions. Tighter standards for judicial review also apply in the takeover context. In the United States, courts have developed a modified business judgment rule for takeovers. The famous decision of Smith v Van Gorkom, 488 A.2d 858 (Del. 1985), which extends the review of the courts to the decision-making process, applies only in the takeover context.
In Europe, a separation between the fiduciary duties on the one hand and the duty of care on the other is generally accepted. Whether the business judgment rule might be applied also to decisions in the monitoring context is still subject to legal debate. In the United States, a common approach has recently been developed where both the monitoring decisions and the taking of control decisions are subject to a good faith test. While the business judgment rule was developed in the 1920s, courts have only recently begun focussing on the monitoring context. Acting in good faith applies in the United States as the standard of review for control decisions and faulty control. Company directors must react to so-called red flags.
3. European regulations and common European principles
Director liability is not harmonized in Europe. The European directives on company law do not cover the liability of board members in stock (stock corporation) or close corporations incorporated according to national law. Even for firms incorporated as European Companies (European Company (Societas Europaea)), different legal regimes exist. Regarding the liability of the members of the managerial, supervisory or administrative organ (eg board), the Council Regulation on the European Company Statute (SE Regulation) points to the legal provisions of the Member State in which the company has its registered office. Efforts to introduce at least a minimum standard for director liability were made concerning companies facing insolvency. A preliminary proposal of the Forum Europeum in this regard was picked up by the High Level Group of Company Law Experts. Their report proposed the introduction of a ‘wrongful trading’ provision similar to the English rule in § 214 of the Insolvency Act. The Commission of the European Union included that proposal in the Action Plan. Later, the desire for a regulatory pause in European company law efforts (the so-called ‘regulatory fatigue’) led to the postponement of this initiative. As is the case for the European Company (SE), the draft statute for a European Private Company (Societas Privata Europaea) refers to the applicable national law.
Common principles of director liability are the duty of care, the duty of loyalty and the business discretion of company directors. All European legal systems recognize the business discretion of directors in running the company. A prerequisite for business discretion is that the director acts in line with his or her fiduciary duties. The business discretion may modify the duty of care. Depending on the doctrinal concept used to provide a safe harbour, either the standard of review differs from the standard of the duty of care or the standard for the duty of care itself is lowered. The duty of care sets out an objective standard for running the company. Since the introduction of the Companies Act of 2006, even under English law, a director cannot avoid liability by claiming that he lacked the necessary knowledge or the ability to act as a corporate director. However, the standard is not purely objective. Under the English Companies Act of 2006, reasonable care, skill and diligence are required.
4. The national legal orders
a) United States as a model for the business judgment rule
The reception of the business judgment rule in Europe bears testimony to the role of US corporation law as the leading legal regime in the past decades. In this context, it has to be emphasized that the business judgment rule in the United States is not codified and it is presumed that the corporate director acts within the scope of his or her duties. Besides the case law, particularly from Delaware, the American Law Institute’s Principles of corporate governance should be mentioned in this regard. This treatise has heavily influenced German debate and the codification of the German business judgment rule. However, the concept of the Delaware courts and the concept of the American Law Institute are to be distinguished. The business judgment rule proposed by the American Law Institute states: ‘A director or officer who makes a business judgment in good faith fulfils his duty if the director or officer: (1) is not interested in the subject of the business judgment; (2) is informed with respect to the subject of the business judgment to the extent the director or officer reasonably believes to be appropriate under the circumstances; and (3) rationally believes that the business judgment is in the best interest of the corporation.’ For the corporate and legal practice in the United States, the case law in Delaware, the most influential jurisdiction in the US for corporate law, is also of relevance. The Delaware Supreme Court formulated the business judgment rule as follows: ‘It is a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company’ and states further: ‘Thus, directors’ decisions will be respected by courts unless the directors are interested or lack independence relative to the decision, do not act in good faith, act in a manner that cannot be attributed to a rational business purpose or reach their decision by a grossly negligent process that includes the failure to consider all material facts reasonably available.’
b) The German business judgment rule
In Germany, in the 1990s, the business discretion of the management directors became the subject of an intense legal discussion which is still going on. In the ARAG v Garmenbeck decision (BGH 21 April 1997, BGHZ 135,°244), the Federal Supreme Court explicitly accepted a broad discretion of the members of the management board and of the supervisory board in making business decisions. According to this landmark decision, an executive director is only held liable if the management board went significantly beyond the boundaries within which a responsible handling of the business can take place, as determined by the interests of the company and its stakeholders (Unternehmenswohl); if the willingness to take risks is irresponsibly overdrawn; or if the conduct of the executive directors is in conflict with their duties in other ways.
The business judgment rule was codified in Germany in 2005 due to proposals from both the German Jurists Association and the Government Commission on Corporate Governance by the Law on Corporate Integrity and Modernization of Judicial Control of the Resolutions of the General Meeting (UMAG). The German business judgment rule is based in particular on the American Law Institute’s Corporate Governance Principles. According to § 93(1)2 German Stock Corporation Act, there is no breach of duty if the director makes a business decision and ‘could reasonably believe’ that he is acting on an informed basis and in the best interest of the company. This provision also applies mutatis mutandis to members of the supervisory board. The significant differences between the German and American systems include the existence of the codification itself, the absence of a distinction between standards of conduct and standards of review and the regulation of the burden of proof. According to the explanatory notes of the governmental draft, it was not intended to switch the burden of proof for fulfilling the duties from the directors to the company. Traditionally, the Federal Supreme Court, in line with the prevailing opinion in academic literature, places the burden of proof on the directors.
The business judgment rule covers only those business decisions where the board could reasonably assume that they were acting for the benefit of the company. Specific acts must be undertaken responsibly. An entirely unreasonable or irresponsible action is not covered by the business discretion of the management board, the supervisory board or a single deciding director. The general standard of review is the irresponsibility of the action taken. Following the explanatory notes of the governmental draft, a management director may not reasonably assume to act in the best interest of the company when he assesses the risk associated with a business decision ‘in a totally irresponsible way’. The explanatory notes of the governmental draft in this context refer to the ARAG v Garmenbeck decision of the Federal Supreme Court whereby there is no safe harbour if corporate directors take irresponsible risks. This applied even before codification of the business judgment rule, with the Federal Supreme Court generally requiring the business decision to ‘significantly’ exceed the boundaries within which a responsible handling of the business based on the interest of the company and its stakeholders (Unternehmenswohl) can take place. According to former judge of the German Federal Supreme Court, Hartwig Henze, the standard of review set by ARAG v Garmenbeck is based on the US business judgment rule; violating these standards is close to waste. Therefore, irresponsibility is the general standard of review for liability of corporate directors, limiting the directors’ freedom of action in running the business of stock corporations. Irresponsibility, as a factor when considering a breach of business discretion, is reflected both in the jurisprudence of the Bundesfinanzhof and in the rationale of the judgments of some of the German Courts of Appeal. Unlike German academics, German courts refer only occasionally to reasonableness as an element of review and when doing so they require a stricter form of reasonableness than usual (namely ‘absolutely’ or ‘completely’ unreasonable actions). The Federal Supreme Court, in an earlier decision, referred to recklessness as the standard of review for the liability of company directors.
The unwritten criteria of the German business judgment rule are that directors act in good faith and in the absence of a conflict of interest. The business judgment rule also requires that the directors have no special interest in the decision taken and that there are no influences related to the subject of the decision. This requirement is not explicitly spelled out in the German Stock Corporation Act, but is instead stated in the explanatory notes and generally accepted in the literature. According to the explanatory notes of the governmental draft, the management board and the single director must be unaffected by conflicts of interest, influences not related to the subject of the decision and must lack a direct self-interest. Corresponding to the US business judgment rule, the explanatory notes also state that the director must be unbiased and independent. For the application of the business judgment rule, the American Law Institute requires that the director has no personal interest in the decision. In Delaware, courts refer to the lack of self-interest and to the independence of the corporate directors.
Good faith is an additional, separate requirement for the application of the German business judgment rule. A member of the management as well as of the supervisory board may only believe to act in the best interest of the company if he or she acts in good faith. This corresponds to the American model with its ‘best interest’ test and the need for a good faith effort as a condition for the application of the business judgment rule. Practically, the standard of good faith serves as a last resort for judicial control of managerial decisions. Good faith alone does not shield a director from liability if the director, due to other reasons, could not believe to be acting in the best interests of the company.
In reviewing the process of the decision-making of the management board, the German stock corporation law has traditionally been very strict. Leading academics claimed that the decision should be based on all accessible information, a view taken also in many comments to the governmental draft of the UMAG. For such strict standards, the Delaware Supreme Court’s decision in Smith v Van Gorkom was also cited. Correctly understood, however, the US business judgment rule does not require the directors to take into account all information available. The American Law Institute test is whether the director could reasonably assume to be acting in the best interest of the company based on appropriate information. In Delaware, it was only in Smith v Van Gorkom that liability of corporate directors was based on lack of information. Yet, since Smith v Van Gorkom was a takeover case, the modified business judgment rule applies. According to general case law in Delaware, at least gross negligence is required. The latter standard was also provided for in the original draft of the UMAG. With the criterion of whether the director could reasonably believe to act on an informed basis and in the best interest of the company, a uniform standard of review for the decision-making process and the decision itself applies. Therefore, also for the decision-making, the standard of review is whether the director acted irresponsibly.
The general standard of irresponsibility should not be misunderstood as the only standard of review. It depends on the particular decision in question which degree of information is appropriate. The leading case for requiring a higher degree of information duties for major decisions is Smith v Van Gorkom, a case rightly regarded as the beginning of takeover law in Delaware. Also in Germany, more stringent information requirements apply to fundamental decisions. Information requirements for the management board as well as the monitoring duties of the supervisory board gradually increase with the importance of the decision for the company. For fundamental decisions, reasonableness rather than irresponsibility is the appropriate standard of review.
c) France and the United Kingdom
In France, a faute de gestion is the crucial test for the liability of board members. This criterion applies both in general company law as well as under the special French provision for the liability of directors of insolvent companies. Even more than in other countries, the liability for violations of the duty of care is of practical importance in insolvent companies. Unlike in Germany and the United Kingdom, the action en comblement de passif covers not only wrongdoing in the area of insolvency but all faute de gestions still relevant for the financial status of the company.
The United Kingdom refrained from codifying a British business judgment rule. The Companies Act of 2006 does not contain an explicit safe harbour for company directors. British directors felt safe due to the traditional reluctance of British courts to hold company directors liable for violating the duty of care. Some liability occurred due to the introduction of the wrongful trading provision in the Insolvency Act of 1986. According to § 214 of the Insolvency Act, a director might be held liable if he did not cease business when there was no reasonable prospect of avoiding insolvent liquidation.
5. Prospects for further European developments
A European regulation of the business judgment rule has never been and is not currently on the agenda. However, there is a European Model Company Law project under way. This European group of academics has begun with the standards for director liability. The outcome might, like other academic projects in the context of contract law, initiate further European discussion towards the definition of common principles or a common frame for company law. Another topic possibly leading to common action in the EU might be the enforcement of the liability of board members. Uniform rules for shareholder action could ultimately lead to common rules on liability. Such common rules should be developed at least for liability with regard to insolvency, given the shift from US to UK corporate law with respect to the UK wrongful trading provision.
Literature
American Law Institute, Principles of Corporate Governance: Analysis and Recommendations (1994); Klaus J Hopt, ‘Die Haftung von Vorstand und Aufsichtsrat’ in Festschrift Ernst-Joachim Mestmäcker (1996) 909; Andrea R Grass, Business Judgment Rule (1998); Theodor Baums (ed), Bericht der Regierungskommission Corporate Governance (2001); Markus Roth, Unternehmerisches Ermessen und Haftung des Vorstands (2001); Holger Fleischer, ‘Die “Business Judgment Rule”—Vom Richterrecht zur Kodifizierung’ (2004) ZIP 685; Susanne Kalss, Vorstandshaftung in 15 Europäischen Ländern (2005); Brian R Cheffins and Bernhard S Black, ‘Outside Director Liability Across Countries’ (2006) 84 Texas Law Review 1385; Klaus J Hopt and Markus Roth, ‘§ 93(1)2, 4 neue Fassung’ in Klaus J Hopt and Herbert Wiedemann (eds), Großkommentar Aktiengesetz (2006); Stefan Grundmann, European Company Law (2007); Jan von Hein, Die Rezeption US-amerikanischen Gesellschaftsrechts in Deutschland (2008); Markus Roth, ‘Outside Director Liability—German Stock Corporation Law in Transatlantic Perspective’ (2008) 8 Journal of Corporate Law Studies 337; Stephen A Radin, The Business Judgment Rule (6th edn, 2009); Klaus J Hopt, ‘Comparative Corporate Governance—The State of the Art and International Regulation’ (2011) 59 Am J Comp L 1.
