All company directors have to use their judgment when making decisions for a company. Indeed, it is such an intrinsic part of being a director that the law formally recognises it in the business judgment rule. This article explains what the business judgment rule is, why it exists and how directors or officers might use it.

What is the Business Judgment Rule?

The business judgment rule is essentially a legal defence that officers – or more commonly – directors can rely on in the face of suggestions or litigation that they have not acted with care and diligence.  The rule is contained in the Act, immediately below the duty to act with care and diligence.

The Corporations Act 2001 (Cth) (‘the Act’) requires all directors and company officers to exercise their powers and discharge their duties with care and diligence.

The duty is not absolute in so far as it requires only that degree of care and diligence that a reasonable person would exercise if they were a director or officer in those same circumstances.  This duty is one of the several important responsibilities that the law places on directors and company officers.

Why Does the Business Judgment Rule Exist?

Legislators introduced the rule to recognise the commercial realities and potential consequences of breaching duties as a director or officer. In short, they allowed for the fact that no commercial decision or action is ever certain.  At times, decisions result in loss and financial difficulty.  While suggestions about what a director ought to have decided or how they should have acted may be instructive, regulators must not use them to punish informed and careful decisions that just failed. The rule also reflects the role of law regarding companies: as a means of increasing transparency and ensuring the correct degree of prudence but not to supervise and stymie honest management.

Relying on the Business Judgment Rule

To rely on the business judgment rule, a director or officer must first show that they made a business judgment and that they made the judgment:

  • In good faith and for a proper purpose;
  • With no material personal interest in the subject matter of the judgment;
  • After they informed themselves about the subject matter of the judgment to the extent they reasonably believed to be appropriate; and
  • With a rational belief that the decision was in the best interests of the corporation.

A director or officer must be able to prove all these elements to rely on the rule. If they do, the Act considers that the director has fulfilled their obligations regarding care and diligence.            

Note that a business judgment constitutes any decision to act or not to act in regards to a matter relevant to the business operations of the corporation.  

Also, a director’s belief that their judgment was in the best interests of the company is taken as rational unless it is one that no reasonable person in that position would hold.

Despite its importance, some have considered the rule a little opaque. Nonetheless, the legal action that the Australian Securities and Investments Commission (ASIC) took against Jodee Rich and Mark Silbermann in the wake of the collapse of One.Tel clarified the rule somewhat.

In particular, his Honour Justice Austin held that:

  • Matters of budgeting, planning and forecasting constitute a business judgment;
  • To determine the reasonableness of a director’s belief that their decision was properly informed requires knowledge of the importance of the judgment, the time available to obtain information and the costs related to getting information. 
  • A person must also consider the director’s confidence in exploring the matter, the state of the company’s business at that time and any other competing demands on the board’s attention as well as whether or not material information was reasonably available to the director.
  • A belief is not rational if there was no arguable reasoning process to support it.
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If you are an officer or director regarding assistance or have questions about how director’s duties may affect you, get in touch with our qualified and experienced commercial lawyers. Call LegalVision today on 1300 544 755.

Carole Hemingway

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