by Joshua B. Rosenzweig (Spring 2017)
Corporations generally consist of three levels of individuals/groups that control and/or oversee the activities of the corporation – shareholders, directors and officers.
Shareholders are the owners of the corporation. Generally, shareholders must act with loyalty toward the corporation, but little else is expected of shareholders with respect to the decisions that impact the viability of the entity.
Directors are tasked with managing the affairs of the corporation. The directors are supposed to make decisions on an informed basis, in good faith and in the honest belief that the action taken is in the best interests of the company.
Officers are the individuals who implement the decisions of the directors. Officers oversee the day-to-day operations of the corporation and ensure that the decisions of the directors are carried forward.
So, what happens if corporate directors make decisions that result in the complete collapse of an entity? For example, a corporation, based on the decision of the board of directors, desires to hire a new employee that ends up embezzling millions of dollars resulting in the corporation having to close its doors. Can a shareholder, or group of shareholders, hold the directors liable for the catastrophic decision? Do the directors have any protection from such a lawsuit filed by the shareholders?
The answers to both of these questions can be found in the “Business Judgment Rule” (“Rule”). Under the Rule, a court will not interfere with the exercise of the business judgment for corporate directors unless there is evidence of bad faith, fraud, illegality, or gross overreaching. (See Wolinsky v. Kadison, 2013 IL App (1st) 111186) The Rule operates as a shield from liability for corporate directors so that a bad decision does not result in personal liability.
The Rule is designed to protect directors from liability for honest mistakes in judgment. (Goldberg v. Astor Plaza Condominium Association, 2012 IL App. (1st) 110620). When corporate directors properly exercise their business judgment, a court will not find the directors’ interpretation a breach of fiduciary duty. The Rule requires that directors exercise “due care” in fulfilling their duties. Due care involves “becoming sufficiently informed to make an independent business decision.”
The Rule protects directors who have been diligent and careful in performing their duties from being subjected to liability from honest mistakes of judgment. (See Stamp v. Touche Ross & Co., 263 Ill.App.3d 1010, 1015 (1st Dist. 1993)) In Stamp, plaintiff brought suit against directors of a corporation for negligence and breach of fiduciary duty, alleging in relevant part that the directors failed to oversee the performance of corporate agents, wrongfully delegated responsibility, and failed to properly manage and supervise their subordinates. The First District found that these allegations were insufficient to defeat the Rule, stating:
[T]hese allegations, as currently framed, attack no more than the defendants’ actual exercise of their business judgment and are consequently within the protected parameters of the business judgment rule. Plaintiff has not alleged that any such failure was by reason of inexcusable unawareness or inattention or lack of good faith on part of the directors.
One component of due care is that directors must inform themselves of material facts necessary for them to properly exercise their business judgment. (See Stamp, 263 Ill.App.3d at 1015, citing Gaillard v. Natomas Co., 208 Cal.App.3d 1250, 1265 (1989) (directors “may not close their eyes to what is going on about them in corporate business, and must in appropriate circumstances make such reasonable inquiry as an ordinarily prudent person under similar circumstances”)) Thus, the Rule is defeated where directors act without “becoming sufficiently informed to make an independent business decision.” (See Ferris Elevator Company, Inc. v. NEFFCO, Inc., 285 Ill.App.3d 350 (3rd Dist. 1996))
Honest mistakes in judgment will not allow for a court to disregard the Rule. However, a failure to account for relevant, pertinent information related to a business decision will result in a court’s imposition of its judgment for that of corporate directors.
In Davis v. Dyson, 387 Ill.App.3d 676 (1st Dist. 2008), condominium unit-owners sued the association and directors for breach of fiduciary duty over a loss resulting from the embezzlement of funds from the condominium association. The First District Appellate Court held that the Rule did not apply to protect the board of directors where the board violated the Illinois Condominium Act by failing to purchase the proper insurance to protect the association’s funds, failed to review the association’s monthly bank statements, which would have revealed the embezzlement, and failed to obtain the advice of counsel to learn about their duties as to insurance coverage, association finances or personnel supervision. Since the directors acted without exercising the due care required, the court found the directors could not avail themselves of the Rule to defeat the claim of the condominium unit-owners.
Practically speaking, a board of directors, regardless of whether it consists of one person or multiple individuals, should always conduct research prior to making a decision on a particular subject. If new computer equipment is an issue, then the directors should consult multiple parties on the best equipment for that corporation’s needs.
But, more than just speaking with other knowledgeable individuals, the directors should document those actions so that there is proof of their efforts. In addition, the directors should make certain that the cost of the new equipment does not exceed what the corporation can afford. Although researching the new equipment is an important step, it is also important to make sure that the decision to purchase such equipment won’t bankrupt the entity.
The Rule will shield corporate directors from liability where the directors have exercised reasonable diligence in making a respective decision. To protect themselves, corporate directors should make sure to conduct research on every decision affecting the affairs of their respective entity and document the research to demonstrate reasonable diligence was exercised in reaching such a decision.