Breaking Down NJ’s Business Judgement Rule

Under the business judgment rule, when business decisions are made in good faith based on reasonable business knowledge, the decision-makers are immune from liability from lawsuits brought by others who have an interest in the business entity...

Under the business judgment rule, when business decisions are made in good faith based on reasonable business knowledge, the decision-makers are immune from liability from lawsuits brought by others who have an interest in the business entity. The rationale behind the rule is to provide a company’s management with the latitude needed to run the business, so long as they act in good faith. 

Rationale Behind Business Judgement Rule

Officers and directors owe the corporation certain fiduciary duties, including a duty of loyalty and a duty of care. A director or officer has a duty to the corporation to perform the director’s or officer’s functions in good faith, in a manner that he or she reasonably believes to be in the best interests of the corporation. In addition, an officer or director must exercise the same care that an ordinarily prudent person would reasonably be expected to exercise in a like position and under similar circumstances.

Violating fiduciary duties can result in significant personal liability, which could make businesspeople reluctant to serve as directors and officers. Accordingly, the business judgment rule was established to shield internal business decisions from second-guessing by shareholders and, ultimately, the courts. As the Appellate Division explained in Maul v. Kirkman, 270 N.J. Super. 596 (1994), “The rule exists to promote and protect the full and free exercise of the power of management given to the directors. So, bad judgment, without bad faith, does not ordinarily make officers individually liable.”

Application of the Business Judgment Rule

The business judgment rule often arises in defense to shareholder lawsuits alleging that officers or directors violated their duty of care to the corporation and caused the corporation to suffer financial losses. Examples include claims of paying too much under a contract, selling assets for too little, altering the products/services offered by the company, entering into a merger or acquisition, or deciding to settle a lawsuit against the company. Lawsuits against co-op and condominium board members by unit owners often frequently involve the business judgment rule.

When applying the business judgment rule, New Jersey courts generally ask two key questions: (1) whether the actions were authorized by statute or by charter, and if so, (2) whether the action is fraudulent, self-dealing or unconscionable. As explained by the New Jersey Supreme Court in In re PSE & G Shareholder Litigation, 173 N.J. 258, 277 (2002): “New Jersey courts have long accepted that a decision made by a board of directors pertaining to the manner in which corporate affairs are to be conducted should not be tampered with by the judiciary so long as the decision is one within the power delegated to the directors and there is no showing of bad faith.”

When the business judgment rule applies, stockholder-approved or ratified corporate actions are to be presumed correct. That means that questions related to management policy, contract execution, bylaw amendments, adequacy of consideration not grossly disproportionate, and lawful appropriation of corporate funds to advance corporate interests are generally left to the discretion of directors and officers so long as they are working within their delegated authority. 

The business judgment rule is, however, a rebuttable presumption. The burden of proof shifts to the defendant to show the intrinsic fairness of the transaction in question upon the showing of fraud, self-dealing, or unconscionable conduct. By way of example, if members of the board award themselves favorable contracts or approve excessive compensation packages for themselves, a court will likely find that this constitutes “self-dealing.” The burden of proof then shifts to the board to demonstrate that their decision-making was fair to the corporation and its shareholders.

Modified Business Judgement Rule

In New Jersey, courts follow a modified business judgment rule with respect to derivative suits (suit brought by shareholders on behalf of the corporation). It imposes an initial burden on the directors of a corporation to demonstrate that in deciding to reject or terminate a shareholder’s suit, the members of the board 1) were independent and disinterested, 2) acted in good faith and with due care in their investigation of the shareholder’s allegations, and that 3) the board’s decision was reasonable. Under the modified business judgment rule, shareholders must also be allowed to access corporate documents and conduct other discovery intended to the narrow issue of what steps the directors took to inform themselves of the shareholder demand and the reasonableness of their decision.

In In re PSE & G Shareholder Litigation,  the corporation’s board of directors rejected a shareholder’s demand to commence legal action on the corporation’s behalf after malfunctions and safety problems at the corporation’s power plants resulted in shutdowns and regulatory enforcement. The New Jersey Supreme Court concluded that the board acted reasonably and in good faith. In support of its decision, the court found that the board members were disinterested and independent when they decided to reject the demand and terminate the litigation, and nothing in the record demonstrated that the directors had divided loyalties, stood to receive any improper personal gain or were unduly influenced by any improper motive. The New Jersey Supreme Court also noted that the board of directors acted in good faith and with due care in investigating the merits of the litigation, as evidenced by their extensive investigation and consultation with an outside law firm. The court also found that the board demonstrated that their decision to terminate the litigation was reasonable by informing themselves of the substance of the shareholders’ allegations and weighing those allegations against the likelihood that the litigation would succeed.

Key Takeaway for New Jersey Businesses

The business judgment rule can afford significant legal protection to directors and officers. However, it is important to be mindful that the doctrine does not provide a complete shield from liability. Directors and officers who neglect to inform themselves of all readily available material information before making a business decision may not rely on the business judgment rule. The same is true for those who abuse their discretion.

If you have any questions, please contact us

If you have any questions or if you would like to discuss the matter further, please contact me, Joel N. Kreizman, or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.