Recent US case discusses the business judgment rule

The business judgment rule is a defence to breach of the statutory duty of care and diligence in section 180 of the Corporations Act 2001 (Cth). The Australian form of the rule is found in section 180(2) Corporations Act 2001 (Cth) and was derived from a common law doctrine of the United States.

The business judgment rule provides a defence for directors who fail to exercise their powers and discharge their duties with the required degree of care and diligence. A director may rely on the defence if they can establish that they:

1. made the judgment in good faith for a proper purpose;
2. did not have a material personal interest;
3. appropriately informed themselves about the subject matter; and
4. rationally believed that the decision was in the best interests of the company.

The American version of the business judgment rule is very similar. It states that the court will not review the business decisions of directors who acted in good faith and on an informed basis, in a manner the directors reasonably believe to be in the best interests of the corporation.¹

The Delaware Court of Chancery is particularly influential in the interpretation of American corporations law because over 50% of US publicly traded corporations and 60% of the Fortune 500 companies are incorporated in Delaware. This is due to the state’s business-friendly corporation law. In view of the similarities between the American and Australian versions of the business judgment rule, the implications of some American judgments are worth examining.

The case – Goldman Sachs shareholder litigation

The Delaware Court of Chancery recently dismissed a claim that Goldman Sachs breached its fiduciary duty to shareholders by approving a compensation structure that encouraged employees to take undue risks. The claim was made by Southeastern Pennsylvania Transportation Authority and International Brotherhood of Electrical Workers Local 98 Pension Fund, two Goldman Sachs stockholders. They brought the action against the financial services company and 14 individual current and former directors.

The claim concerned a ‘pay for performance’ compensation structure that connected employee remuneration to company performance. The plaintiffs asserted that the pay structure encouraged risky trading practices, over-leveraging of the company’s assets and significant exposure to credit risks.

Allegations also included that the directors made risky business decisions and allowed risky business decisions to be made by others, that Goldman Sachs’s remuneration structure encouraged its employees to increase revenue without considering risk, and that the structure put the interests of Goldman’s management and stockholders at odds.

The decision

Vice Chancellor Sam Glasscock III dismissed In re the Goldman Sachs Group Inc. Shareholder Litigation, on the grounds that the plaintiffs had not provided sufficient factual allegations in their pleadings to raise reasonable doubt that the Goldman Sachs directors acted in good faith and on an informed basis when they implemented a compensation scheme that allocated profits between the employees and shareholders.

Glasscock, V.C. stated that directors and officers need to have broad freedom to pursue opportunities, as long as they do not contravene fiduciary obligations. A risky decision or strategy does not automatically breach those obligations.

There is nothing intrinsic in using naked credit default swaps or shorting the mortgage market that makes these actions illegal or wrongful. These are actions that Goldman managers, presumably using their informed business judgment, made to hedge the Corporation’s assets against risk or to earn a higher return. Legal, if risky, actions that are within management’s discretion to pursue are not ‘red flags’ that would put a board on notice of unlawful conduct. (at 55)

Glasscock, V.C. repeatedly looked to the plaintiffs to present compelling and particular facts that demonstrated how the directors did not act in good faith, and were not adequately informed. The plaintiffs’ case failed because they were unable to provide such detailed and relevant facts.

Implications for Australian company directors

While this case is not binding in Australia it is worth looking at because not many Australian cases relating to the business judgment rule come before the courts, so there is not much judicial discussion of the issues.

The facts of this American case appear to fit within the criteria set out in section 180(2) of the Corporations Act 2001. Glasscock, V.C. considered whether the decisions were made in good faith, and on an informed basis. He separately considered whether the directors were sufficiently independent and disinterested and made no finding of material personal interests that might influence their decision making.

This case then serves to remind that the business judgment rule considers whether directors act rationally and carefully, and looks to specific actions to demonstrate care taken or lacked. Risky strategies or policies do not inherently demonstrate a failure of business judgment.

To discuss any issues relating to this bulletin, or any other corporate governance or compliance issues, please contact David Grace on +61 7 3231 2421.
¹ Aronson v. Lewis, 473 A.2d 805, 812, 814 (1984); Brehm v. Eisner, 746 A.2d 244, 256 (Del. 2000)