Rescuing the director – can the business judgment rule be at your rescue?

August 1st, 2023
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Picture source: Gallo Images/Getty

By Karabo Sekailwe Orekeng

The business judgment rule (the rule) is a defence mechanism found in s 76 of the Companies Act 71 of 2008 (the Act). The rule can be used by directors who face potential liability owing to a breach of their fiduciary duties. However, there are three crucial requirements that must be met in order for the defense to be available to a director.

Section 76(4)(a) of the Act, encapsulates the following requirements:

  • ‘The director took reasonably diligent steps to become informed about the matter at hand;
  • The director had no material personal financial interest or conflict of interest in the matter, or had dealt with those personal financial interests as required by law; and
  • The director rationally believed that the decision made or supported was in the best interest of the company and had acted in good faith in the best interest of the company’ (see Keira-lea Sandilands ‘What is the Director’s Protective Mechanism as per the Companies Act’ (https://serr.co.za, accessed 19-5-2023)).

Section 76(4)(b) of the Act states that directors can rely on the performance, information, recommendations, and opinions of professional advisors. However, when doing so, the director must have reasonable belief that the recommendations can be relied on and must reasonably rely on the advisor’s competence. Therefore, in order for this section to apply, the director must not baselessly rely on the information but should scrutinise the information even if it comes from professional advisors (see Sandilands (op cit)).

‘In Aronson v Lewis [473 A.2d 805 (Del. 1984)], the Delaware Supreme Court interpreted the business judgment rule as a presumption that when directors make business decisions for the company,’ these decisions taken by the directors must be made ‘in good faith, and in the honest belief that the decision was in the best interest of the company’ (see Sandilands (op cit)).

The extent of a director’s duty of care and skill depends on the nature of the business the company is partaking in, and South African law does not require a director to have absolute business acumen (see Deshara Pillay and Parmi Natesan ‘The business judgment rule’ (www.financialmarketsjournal.co.za, accessed 31-3-2023)).

Business is about taking risks for rewards and directors, when exercising their judgment and making decisions for a company, need to do so with the goal of furthering the companies’ interests. However, even the best-orchestrated plans fail. In those instances, what needs to be assessed is the relevance of the decisions taken by the directors and this is not only based on results of the decision but is also based on the procedure/s the directors followed when the decision was taken (see Pillay and Natesan (op cit)).

Van Tonder states that the business judgment rule does not apply to the situation where the directors have failed to exercise their duties of oversight and monitoring this is due to the rule only applying in instances where the directors have made a business decision (see Jan-Louis van Tonder ‘An analysis of the directors’ decision-making function through the lens of the business-­judgment rule’ (2016) 37 Obiter 562). Failing to exercise oversight and monitoring duties amounts to a failure to act and does not translate to making a business decision. The author states that there must be evidence of an informed, deliberate, and good faith process of decision-making taken by the directors for the rule to apply. This situation is different to directors having a positive obligation and failing to act, the directors’ decision not to act does not constitute a business decision.

Requirements of s 76(4)(a) of the Act

The first requirement states that the director must have ‘taken reasonably diligent steps to become informed about the matter.’ The assessment of steps taken to become informed is objective. The directors are required to take initiative to be informed of a matter prior to taking a decision. If presented with a report, they should read the report with a curious mind and interrogate the contents with the lens of protecting and acting in the company’s best interests.

A director must be able to demonstrate that when they received the information, they critically considered the information prior to making their business decision. Whether or not a director made an informed decision a court would have to grapple with the surrounding circumstances. In terms of the second requirement, ‘the director must not have a material personal financial interest in the subject matter of the decision’ (see Linda Muswaka ‘Shielding directors against liability imputations: The business judgment rule and good corporate governance’ (2013) SPECJU 25).

The third requirement indicates that the director must have a rational basis to believe that the decision was taken in the best interest of the company. The test for rationality is objective. In order to satisfy a rational belief, ‘directors must be independent with respect to the action’ taken. ‘A director is independent when he or she is in a position to base his or her decision on the merits of the issue rather than being governed by extraneous considerations’. Ultimately, directors must believe that the decision they have taken was in the best interest of the company and such belief must have a rational basis. Therefore, whether the rule will apply falls heavily on factual evidence provided and surrounding the conduct or decision-making process at issue (see Muswaka (op cit)).

The rule applied in United States (US)

In the US case of Smith v Van Gorkom 488 A.2d 858: ‘The Delaware Supreme Court had to decide about a derivative suit against the members of the board of directors. These members had decided to sell the company by issuing the share for a price of 55 $ each. The shareholders … alleged that this purchase price had been too low and the board [failed] to obtain a higher price. The Supreme Court examined the information basis for the purchase decision in detail. In order to prepare the purchase decision, the board got an expert opinion … . Based on these findings, the CEO negotiated with the subsequent buyer on his own without informing the other board members or the shareholders of the company.’ The Delaware Supreme Court found that the process leading up to the decision taken was not adequate to prepare an important decision for the given sale of the company. Therefore, the court found that the board failed to fulfil its obligation to be properly informed of what real value of the company was. According to the Delaware Supreme Court the duty to be informed also requires directors to be critical of the information it receives (see Dr Stefan Eisele Codification of the business judgment rule in section 76(4) Companies Act 2008: Comparing the South African with the German approach (LLM thesis, University of Cape Town, 2017)).

In the case of Percy v Millaudon 8 Mart (ns) 68 (La 1829), the shareholders of a bank sued its directors. The shareholders alleged that due to the misappropriation of funds by the bank’s president and cashier, the directors of the bank were liable for the losses suffered by the company. The Louisiana Supreme Court held that: ‘When the person who was appointed attorney-in-fact, has the qualifications necessary for the discharge of the ordinary duties of the trust imposed, we are of the opinion that on the occurrence of difficulties, in the exercise of it, which offer only a choice of measures, the adoption of a course from which loss ensues cannot make the agent responsible, if the error was one into which a prudent man might have fallen’ (see Friedrich Hamadziripi and Patrick C Osode ‘The nature and evolution of the business judgment rule and its transportation to South Africa under the Companies Act of 2008’ (2019) 3 Speculum Juris). The effect of the court’s ratio decidendi encouraged people to take up office of director allowing room for mistakes, which is at the core of the rule.

The rule applied in Canada

In Maple Leaf Foods Inc v Schneider Corporation 42 OR (3d) 177 (1998) OJ No 4142, the appellant, was a bidder for Schneider’s shares. ‘The appellant had declared its intention to make an unsolicited take-over bid for Schneider at $19 a share. After the establishment of a special committee by the respondent and some consultations between the former and the latter’s board of directors, Schneider ended up accepting Smithfield Foods’ offer of $25 a share. The appellants alleged that the agreement between the Schneider family and Smithfield Foods unfairly disregarded the interests of non-family shareholders and prejudiced them. It was held that: “the court looks to see that the directors made a reasonable decision not a perfect decision. Provided the decision taken is within a range of reasonableness, the court ought not to substitute its opinion for that of the board … . As long as the directors have selected one of the several reasonable alternatives, deference is … accorded to the board’s decision”’ (see Hamadziripi and Osode (op cit)).

Conclusion

The rule is a form of protection for directors and allows them to make informed decisions even if they face the threat of liability to the company and shareholders because of the desired outcome not being reached. What can be gleaned from the above is, directors should take informed decisions, such decisions should be taken in good faith and said director should not have an interest in the business transaction to rely on the rule. If the director acts contrary to this, by acting in bad faith and taking a decision that personally benefits them, the rule will not protect them and thus be inapplicable. It is also evident that the rule allows room for ‘honest mistakes’ and appreciates that there is no perfection in company decision-making (Hamadziripi and Osode (op cit)). Directors should thus be encouraged to act honestly and ‘with integrity in board decisions and activities’ (Muswaka (op cit)). This is done when a director does not accept information at face value and rather makes a thorough analyses of the information first. It is, therefore, prudent for directors to familiarise themselves with the business, finances and long-term or short-term objectives of the company.

Karabo Sekailwe Orekeng BA Law BA (Hons) (Economics) LLB (Rhodes) is a candidate legal practitioner at DMS Attorneys.

This article was first published in De Rebus in 2023 (Aug) DR 22.

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