Why is the business judgment rule important and how can it help my business?

The business judgment rule is a presumption in the law that favors the board of directors or managers of a company.  The rule presumes that when making business decisions, those in charge have “acted on an informed basis, in good faith and in the honest belief that the action was in the best interests of the company.” Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984).  There is no protection for managers or directors who have made unintelligent or unadvised judgments.  Directors and managers have a duty to act in an informed and deliberate manner, and they are not to leave key decisions, such as a merger, sale, or acquisition to the stockholders alone.  A managers’ or directors’ decisions will be measured in this duty by the way that they have informed themselves of all material information that is reasonably available prior to making a decision.  Gross negligence will most likely be the proper standard to determine if the managers or directors have not reached an informed decision.

 

So what does this mean for you?  Well, lets take the example of John, who is a part owner and full time manger of Donuts, LLC.  Soba Donuts has decided to buy out John’s interest, as well as the rest of the LLC members’, shares.  John is in charge of negotiating with Soba, and making sure that they are getting a good price for the company and its assets.

 

John will want to make sure that he does his homework on the deal to assure himself, as well as the rest of the members of the LLC, that the price Soba offers is fair and reasonable, and that it will be advantageous to the business and the shareholders.

 

Lets first look at the way in which John should not execute this sale.  Jane, the owner of Soba Donuts, calls him and they discuss the matter, and she offers him a price.  Her offer is contingent upon all of the members of Donuts, LLC agreeing to the deal in the next two hours, that day.   John may have a handle on the company’s worth, as well as what it makes, and might be able to come up with a pretty good estimate of the business, but John could be exposing himself to potential future liability if he doesn’t do more to make sure that her offer is good for all of the members.

 

A better way to effectuate the deal would be to make sure that he does his due diligence.  He needs to have accurate data from his accountant, or bookkeeper on the value of the company, its current assets and liabilities, and what their profit margins are, as well as the return on investment that they are currently making for their business.  An even better idea would be to pay a business valuation expert a fee to value the business and come to a more definite conclusion of what the business is worth.  He should then compare that number to Jane’s offer.   The other members of the business should be given adequate time to figure out if they like the deal.  They need time to evaluate their investment, and what they will be getting for their shares of the business.  Some owners may be in the business because they love donuts, and not because they want to make money.  Those types of people might require more of a premium for their shares, or different terms than the other members, in order to sell their shares.

 

Once John does his homework in the right way, he can rely on the business judgment rule to protect him from future lawsuits brought by a disgruntled former shareholder who, down the road, thinks that they could have gotten more for the business, or thinks they should have held out longer to get a better deal with better terms.   If John followed the proper procedures for such a sale, as set forth in the LLC’s operating agreement, and has put forth the effort required to become properly informed of the value of his company, his actions will be protected by the business judgment rulle and he will not have to worry about future liability for his actions in the deal.

 

Talk to your local counsel in order to determine what due diligence you need to perform in order to protect yourself from liability through the business judgment rule.

 

 

Photo By: Moyan Brenn