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Company directors have a duty to act in the best interests of the company and perform their role with care, diligence and skill. Running a business is complicated, however, and sometimes the most well-intentioned decisions go badly. The ‘business judgment rule’ recognises this risk and protects directors against claims that they were acting without care when making legitimate and reasonable business judgments which did turn out as planned. In this article, we set out:

  • what the business judgement rule is; 
  • why it exists; and 
  • how directors might use it.

Directors’ Duties

Directors are responsible for managing their company and must comply with certain duties when doing so. For example, some of the duties set out under the law include directors’ duties to:

  • exercise their powers and duties in good faith and in the best interests of the company;
  • perform their role with care, diligence and skill;
  • avoid conflicts of interest;
  • ensure the company does not trade while insolvent; and
  • not use their position improperly.

If a director makes a decision on behalf of a company that leads to negative results for the company, the director may be personally responsible. However, this may not always be fair. If this is the case, the business judgment rule allows directors to protect themselves against such claims.

What Is the Business Judgment Rule?

One of the key duties a director has under the law is to exercise their powers and discharge their duties with care and diligence. The business judgment rule is a defence that directors can seek to rely on in the face of claims that they did not act with care and diligence.

Under the rule, a director can argue that they made a business judgment with sufficient care and diligence if they:

  • made the judgment in good faith for a proper purpose;
  • did not have a significant personal interest in the subject matter of the judgment;
  • informed themselves about the subject matter to the extent they reasonably believed was appropriate; and
  • rationally believed that the judgment was in the best interests of the corporation.

Importantly, the director must be able to prove all four of these requirements to rely on the business judgment rule. 

What Is the Purpose of the Business Judgment Rule?

The business judgment rule recognises the:

  • commercial reality of running a business (not every decision is going to be a good one); and 
  • potential consequences of breaching duties as a director (i.e. serious personal responsibility). 

The business judgement rule acknowledges that no commercial decision or action is ever certain. Therefore, even well-intentioned decisions can result in loss and financial difficulty. It does not make commercial sense to punish directors for making informed and careful decisions simply because those decisions failed. 

How Is the Business Judgment Rule Used?

The business judgment rule is used as a defence when it is claimed that a director has not exercised their powers and duties with care and diligence. 

When directors rely on the business judgment rule in court cases, courts have considered whether the director:

  • can rationally explain how they arrived at the decision;
  • had information at the time which made the decision justifiable and understandable;
  • received legal advice on the matter;
  • carefully considered the decision and its potential risks in various meetings and discussions;
  • did not have a personal interest in the decision; and
  • put relevant safeguards in place to address potential risks with the decision.

Key Takeaways

The law aims to hold directors accountable for their actions and encourage them to govern their companies responsibly. However, the law also recognises that business is risky and sometimes well-considered decisions can lead to bad results.

The business judgment gives directors a way of defending themselves against claims that they have not acted with care and diligence if they can prove that they have made rational, informed business judgments in good faith and not for their personal interest. If you are a director of a company and need assistance in ensuring that your company is making decisions in compliance with corporate law and proper company processes, contact LegalVision’s business lawyers on 1300 544 755 or fill out the form on this page.

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