Biz judgement rule and directors' liability

In a company, the board of directors (hereafter, board) has the statutory authority and responsibility to manage and govern the company. The board is the trustee of the funds entrusted to the company by shareholders. The auditor is also a key actor in corporate governance. Shareholders appoint the auditor to report whether financial statements are presenting the true and fair view of the financial position and performance of the company. The auditor’s responsibility also includes reporting fraud or suspected fraud, although he/she is not expected to dig out frauds. The Company (Auditor’s) Report Order (CARO) requires the auditor to report on some specific important issues which are of interest to shareholders and regulators. In a way, the auditor reports to shareholders whether the board applied fiduciary standards in decision-making. However, he/she does not comment on the quality of business decisions and the process of decision-making.

The board and directors have two fiduciary responsibilities — duty of care and duty of loyalty to the company. The duty of care requires the board and every director to make decisions in good faith and reasonably prudent manner. The duty of loyalty implies that the directors should be completely loyal to the company. They should avoid possible conflicts of interest, should not involve in self-dealing by taking advantage of the corporate information, and should keep the information received as members of the board confidential.

The board and directors develop perceptions about the probable changes in the internal and external contexts and form judgement on the outcome of alternatives before making a decision. Genuine errors in forming judgement is always a possibility. In the interest of the company, the board and directors must be allowed run the company without the fear that they will be held liable for decisions that might be construed as inappropriate with the advantage of hindsight. The ‘business judgement rule (the rule)’ provides immunity to the board and directors from liabilities that might arise if the company and shareholders suffer loss because of genuine error in judgement.

The rule does not allow the courts to second guess business decisions taken by the board unless it is established that the board blatantly violated the fiduciary standards – the duty of care and duty of loyalty or the decision-making process was tainted, say, because of lack of independence or with interestedness. It aims to balance the need to protect the interest shareholders (equity) and protect the statutory right of the board to run the company without fear. Other two drivers of the rule are: (i) Respect for the private ordering of the corporate governance arrangements (as reflected in internal documents of the company), which usually grant extensive authority to the board to manage the company; and (ii) recognition by the courts that they are not business experts, making deference to board authority a necessity.

Directors, including independent directors, are equally liable for omissions and commissions of the company. However, they are protected if they apply the highest fiduciary standards. A director should act in the same manner as a reasonably prudent person in his/her position is expected to act. The duty of care requires the director to collect information that is necessary for due diligence, act in good faith, and form a rational judgement without the presence of a conflict of interest. In evaluating whether the director has applied the fiduciary standard of ‘duty of care’, the court takes into account competencies of the director based on his/her training and experience. For example, the level of due diligence expected from an accountant on an accounting issue is higher than that of a non-accountant.

The most important challenge that independent directors usually face is gathering sufficient information relevant for deciding on a particular issue. It is the responsibility of the independent director to assess whether the agenda note provides sufficient information. He/she should ask for additional information if required. He/she should also keep himself/herself informed of changes and likely changes in the internal and external contexts between two board meetings. He/she cannot take the plea that the management did not keep him/her informed. Good corporate governance practice requires the management to keep directors informed and to provide detailed information in the agenda papers, but the onus of gathering information lies on the director.

The rule has worked well over the last hundred years, as courts recognise shareholders’ primacy and shareholder value creation as the primary objective of a company. We have to wait and watch how the rule will be interpreted by courts when investors and regulators expect companies to act responsibly towards all-important stakeholder groups.

The writer is director of the Institute of Management Technology Ghaziabad 
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