The new Companies Act of 2008 clearly and concisely defines the business judgement rule in relation to directors.
The business judgement rule in the new Companies Act of 2008.
A fundamental paradox lies at the heart of company law.
On the one hand, one of the main purposes of limited liability companies is to provide a legal structure that will encourage entrepreneurs to engage in entrepreneurial risk-taking without being personally liable for the debts of the business and thus without risking personal bankruptcy if the venture fails.
On the other hand, the law requires directors, in their capacity as the top-level management of the company, to exercise care, skill and diligence in the performance of their duties, and this includes the duty not to expose the company to financial loss by taking undue risks.
Acceptable risk-taking and unacceptable risk-taking by directors
What are the criteria that the law applies to draw the line between "acceptable" risk-taking in this regard, and "unacceptable" risk-taking which may expose the directors to legal liability to the company for failure of their duty?
Since the earliest days of company law in the 19th century, judges have struggled to formulate clear and practical legal criteria in this regard. It is fair to say that judges generally took a lenient approach to directors' legal duties in this regard.
Over time and in the course of many judgments, the judiciary developed a common law business judgement rule - that is to say, a rule that essentially said that if directors, in managing a company, made a decision that was informed and rational, they would not incur any legal liability if the decision turned out badly for the company and caused it to suffer financial loss.
One of the most important features of the new Companies Act of 2008 is that the business judgment rule has now been incorporated into the Act, and clearly and concisely stated.
Thus, section 76(4) now provides that a director will have satisfied his legal duty to act in the best interests of the company and with the requisite care, skill and diligence if -
- he had taken reasonably diligent steps to become informed of the particular matter;
- he had no personal financial interest in the matter and no related person had any such personal interest, or that he had made proper disclosure of such interest;
- he made a decision or supported a decision made by other directors and had a rational basis for believing that the decision was in the best interests of the company.
It follows, conversely, that a director will have breached his duty to the company if he made a decision -
- without taking steps to become informed in relation to that decision; or
- had a personal financial interest in the matter, that he had not properly disclosed;
- that was irrational.
Clearly, therefore, a director will be at risk of incurring legal liability if his decisions are ill-informed, or tainted by an undisclosed personal financial interest, or are haphazard and irrational.
It is unlikely that the courts will regard this new statutory business judgement rule as setting the bar for legal liability higher than it was before. But the statement of this important legal principle in plain language will undoubtedly be welcomed by the business community who are well aware of the legal hazards that a directorship holds in the modern corporate world.