Business Judgement Rule Under Australian Corporation Law

Introduction and Background

There have been many large businesses that have collapsed unexpectedly in recent years, causing irreparable damage to investors worldwide. The most prominent cases are the fall of the U.S.-based Enron International and the Australian firm HIH Insurance. These cases shook the faith of stakeholders in the ability and the intention of the directors who were in charge of operating these enterprises, and also made it harder for directors to negate the fiduciary duty imposed upon them by law. For instance, according to the 1997 Directors' Duties and Corporate Governance of Australia, "There has been increasing debate in Australia about the standard of corporate governance, particularly in light of the experiences of the late 1980s. On the one hand, there have been calls by investor and shareholder groups for greater accountability by directors. On the other hand, directors have been demanding greater certainty in respect of their potential liabilities having regard to notable corporate civil litigation cases."¹

According to Farrar (1997), Australia shares a "confused inheritance of English Law with regard to the duty and standard of care of company directors" with the United Kingdom, but Australia differs from the UK by drawing on the business judgement rule as developed in the United States in an effort to provide corporate directors with a defence against negligence liability when their business decisions are made without self-interest and in good faith.² Moreover, Australia was also an early mover in attempting to clarify and codify these protections for corporate directors. In this regard, Farrar (1997) adds that "Australia was the first in the British Commonwealth to enact a statutory duty in s 107 of the Victoria Companies Act 1958," which simply stated that a "director shall at all times act honestly and use reasonable diligence in the discharge of the duties of his office."³ This legislation subsequently served as the foundation for comparable provisions in the Uniform Companies Acts that were passed by each Australian state during the period between 1961 and 1963.

The general requirement on the part of stakeholders — and more especially shareholders — is that the business be run in a profitable manner, with an honest effort to maximise shareholder value without engaging in unduly risky enterprises or taking actions that, however well-intentioned, are not in the company's best interests.⁴ It is apparent that a balance must be struck between these two viewpoints. Directors must exercise a duty of caution, but sometimes even the best-intended and well-considered decisions do not achieve their intended results — outcomes that could result in litigation and reputational damage to management even where there is no evidence of dereliction of duty.

In this environment, the business judgement rule provides substantive protections for corporate directors who can demonstrate that they reached a given decision based on a prudent business perspective. According to Black's Law Dictionary, the business judgment rule "immunizes management from liability in corporate transactions undertaken within both the power of the corporation and the authority of management where there is a reasonable basis to indicate that the transaction was made with due care and in good faith."⁵

In some cases, directors make innovative business decisions intended to improve a firm's earning quality and taken with the welfare of shareholders in mind, but these decisions are not always successful. The historical record confirms that some decisions can backfire in a highly charged and dynamic marketplace. In sum, the business judgement rule protects directors accused of making wrong decisions provided that certain conditions are satisfied. Greenhow reports that "the business judgment rule will protect those directors who make business judgments in good faith and for a proper purpose, have acted on an informed basis without material personal interest, and who have a rational belief that the decision is in the best interests of the corporation. If one of these requirements is not met, the rule will not provide any assistance."⁶

These protections are important because directors always work in a fiduciary position on behalf of shareholders and all their activities are expected to be devoted to increasing shareholder value. Directors are required to act honestly and faithfully without taking decisions that are against established corporate policies. Naturally, shareholders want directors to act in a manner that increases not only their wealth but also maximises profitability; however, in some cases the desired outcomes may not be achieved notwithstanding the best decisions made by directors from a prudent business perspective.⁷

As of 13 March 2000, a statutory business judgment rule became effective in Australia pursuant to the Corporate Law Economic Reform Program Bill 1998, approved in October 1999. As a result, Greenhow (1999) emphasises that "the position is now clear — the merits of bona fide business judgments made by directors… will not be subject to judicial review. Directors will be taken to have met their duty of care and diligence."⁸ Likewise, the decision in Australian Securities and Investments Commission v Rich (2009) 236 FLR 1 (ASIC v Rich) renewed interest in the business judgment rule in Australian corporate law, such that the rule is capable of providing a defence in cases that would otherwise amount to a breach of a director's duty.⁹

The business judgement rule therefore, according to Gevurtz (2013), acts as a lifeline for the embattled community of directors and others in management from liability that might be invoked by shareholders when decisions are taken within the intra vires powers of the corporation and within the powers granted to the board — provided such decisions are taken with due care and honesty.¹⁰ From the perspective of Gevurtz and like-minded critics, "directors should not be treated any differently from doctors or lawyers and that business decisions are very similar to decisions of other professionals."¹¹

Three main factors serve to differentiate other professionals from corporate directors:

First, other professionals undergo extensive theoretical training (usually six years to complete a degree) followed by a period of practical training. Directors, while usually possessing university qualifications, must adapt to the philosophy and culture of the company, bearing in mind the nature of its activities.

Second, other professionals act within a narrow range where variables are relatively constant and protocols exist to be followed. Directors, by contrast, operate in an unpredictable environment where factors such as economic conditions are outside their control.

Third, at the end of a treatment (in the case of doctors) or a transaction (in the case of lawyers), the professional relationship concludes. Directors are in a continuing relationship with the company and are more akin to permanent consultants than sub-contracted experts.

After-the-fact review of the decisions made by corporate directors nevertheless involves determinations of the same kind applied to other professionals who are required to take risks in their fields of endeavour.¹² According to Greenhow, some have considered that the rule fails to recognise the practical workings of a board, noting that "boards operate by consensus and are more collegial than faculties. It is not so much a matter of what they do but what they do not do that is important."¹³ Because the business judgment rule focuses on the decisions made by directors, an increasing number of corporate boards may feel compelled to develop a paper trail to secure the protections it affords. As Greenhow concludes, "When directors are faced with the possibility of litigation and therefore cautious about the nature of the documents that are created and retained, a paper trail may be revealed evidencing a proper purpose when there may be some ulterior improper purpose."¹⁴

Taken together, it is clear that there are divergent views about the business judgement rule's impact on Australian corporations — an issue that this paper seeks to examine.

The business judgement rule presumes that those who have undertaken informed and honest decisions with the sole intention of benefitting the company and its stockholders must be protected from litigation in cases where those decisions fail to deliver substantial benefits to stakeholders.¹⁵ The rule is therefore intended to serve as a bulwark for directors who act in a prudent fashion based on a good faith effort and known facts to maximise shareholder value. The American Legal Institute sums up the same risk-taking rationale by stating that "if the courts of the land continue to second-guess every decision taken by the board of directors of a firm, then prudently speaking business would come to a halt." It therefore becomes imperative to give protection to decision-makers, even if they fail, so that they may learn, make better decisions in future, and encourage the risk-taking activities that fuel economic growth.

The general corporation law prescribes that a corporation is administered by the board of directors under the express intent of shareholders, not by the stockholders themselves, and thus board members are entitled to act to the best of their ability and belief to preserve, extend, and bring prosperity to shareholder investments. Board members should not be made to fear persistent litigation, and such practices by individual shareholders should not be allowed to deter the work undertaken by the board of directors.¹⁶

The determination of whether a director acted in this fashion can be a highly subjective analysis depending on the perspective of the analyst and the precise circumstances in which the decision was made. Consequently, there are a number of grey areas that prevent the wholesale application of the business judgement rule to all decisions made by corporate directors and that require further investigation.

The objectives of this dissertation were to deliver a systematic and critical review of the relevant literature to develop informed and timely answers to the following guiding research questions:

(a) Is it beneficial for shareholders to keep board members on tenterhooks by continually invoking principles of negligence and undue risk?

(b) Given that many business decisions have succeeded precisely because directors undertook considerable risk, how would shareholders decide how much risk is too much — and would there be sufficient time for the board to consult shareholders in such circumstances?

(c) What is a fair judgment and what impact does it have on the business, profits, and assets of the firm under analysis?

The scope of these research questions extends to all Australian states and territories, and their relevance is grounded in Section 180(2) of the Corporations Act 2001.

Director Risk-Taking and Shareholder Accountability

Directors today are on the front line of corporate operations and the decisions they make can spell the difference between sustained success, mediocrity, and outright failure. Furthermore, the business environment in which corporate directors operate has become increasingly competitive and complex as a result of rapid globalisation, and current signs indicate that these trends will continue to accelerate. There is therefore a corresponding need for corporate directors to identify opportunities for growth that are not unduly risky — propositions that are challenging even under optimal circumstances. Indeed, there is some level of risk involved in virtually any business venture, and navigating large corporations through these complex waters has become especially challenging in recent years.

The fine line that directors must walk with respect to how much risk is too much versus not enough is narrowed even further when the business judgement rule is applied by any stakeholder — including the courts — in ways that tend to second-guess the rational basis and selection of factors upon which a business decision was made. One legal analyst reports that "the balance between entrepreneurial risk-taking and a director's corporate responsibility are inversely correlated under current securities law. The success of any corporate enterprise is entrenched in the ability of its executive management to facilitate and incorporate risk as a function of its operating capability. It is antithetical to contend that shareholder value can be created without undertaking some risk, as it is a fundamental component of the corporate profit-return ratio. Of course, these principles must be balanced in light of those directors who embrace risk as an extremity and who carelessly and dishonestly destroy value through overzealous adoption. While Australian corporate law has attempted to balance these conflicting notions with the enactment of risk assessment provisions such as the business judgement rule in s 180(2) of the Corporations Act 2001 (Cth) — the degree to which the law fosters and encourages directors to undertake structured entrepreneurial risk still remains questionable."¹⁷

So far as exposure to liability is concerned, exposures are increasing in both the criminal and the civil areas. Certainly, the argument can be made that it makes good business sense to ensure that corporate directors are fully aware of their fundamental responsibilities to increase shareholder value while avoiding negligent decisions that involve undue risk-taking. In response to these concerns, one of the main recommendations of the 1989 Cooney Report was that "a business judgement rule be introduced into Australian company law." The report further stated that such a rule "should include an obligation of directors to inform themselves of matters relevant to the administration of the company. They should be required to exercise an active discretion in the relevant matter or, alternatively, to show a reasonable degree of care in the circumstances."

This recommendation was made in response to the fear experienced by Australian directors regarding both criminal and civil liability — a fear arising from what was perceived to be the subjective interpretation of the obligation on directors to exercise skill and care in the performance of their duties. The Cooney Report thus recommended the establishment of a clear objective duty of care for directors in Australian companies legislation. An objective standard of the proper exercise of directors' duty of care was defined by the Report as "one that all individuals would be expected to meet, regardless of their particular capacities and circumstances."¹⁸

The realistic assessment of risk is a core component of the decision-making process and is vital to the achievement of corporate profitability. To assert that shareholder value can be adequately returned without a degree of risk incorporation is to misunderstand the nature of the corporate entity. Section 180 of the Corporations Act 2001 (Cth) seemingly merges the law of negligence at common law with the fiduciary nexus that must exist between a director and a company. It seeks to require a director to discharge their duties in a manner, and with a degree of care, that a hypothetical reasonable person would exercise given the company's circumstances, the director's position, and the level of responsibility within the corporation.¹⁹

The question as to whether a director has exercised reasonable care and diligence within the confinements of their statutory duties can only, as Ipp J explained in Vrisakis v Australian Securities Commission, "be answered by balancing the foreseeable risk of harm against the potential benefits that could reasonably have been expected to accrue to the company from the conduct in question." In this light, it seems apparent that a subjective element to s 180 should be required, as opposed to the objective comparison with the hypothetical reasonable person. Such an element should be incorporated into s 180(2), which purports to ascertain whether a director has made a rationally executed decision — termed the business judgement rule. The rule attempts to act as a defensive shield for directors in determining whether their decision was made in good faith and with a proper purpose relevant to s 180(1).

The purpose of the business judgement rule was outlined in the Corporate Law Economic Reform Program Bill: directors should not have to continuously consider the legal uncertainties of their actions but should instead focus on undertaking rational decisions that encourage innovation and responsible risk-taking. Despite this stated intention, the rule has had little judicial exposure at common law because of its strict objective nature and overbearing requirements. The reliance on the hypothetical reasonable person holds a director in the same judicial position as that required under s 180(1), which affords no realistic utility to the defence. For example, the requirement in s 180(2)(c) — that a director be informed about the subject matter of a decision to an extent "reasonably believed to be appropriate" — infers that the court will objectively determine the reasonableness of the care and diligence exercised by the director in making the decision. In a narrowly constructed light, it is difficult to imagine that the court will look favourably on decisions that adopt a significant component of risk.

It is contended that this is an organic deficiency of s 180(2), since the inherent nature of entrepreneurial risk-taking requires a merit-based assessment of available information before the risk is undertaken. The construction of an objective review of a director's decision-making process only articulates the procedural steps taken in reaching the decision. This arguably poses a significant element of retrospectivity — or "hindsight review" — which questions the reasonableness of the decision in light of an adverse outcome. This would, for example, provide no practicability to a director attempting to stave off liquidation by adopting an entrepreneurial risk that may rescue the company. Companies in great financial difficulty or on the verge of collapse often require a higher degree of entrepreneurial risk in an attempt to preserve shareholder value. In light of s 180(2), such a course of action would seem nonsensical, as a complainant could readily argue that no "rationality" existed in a director attempting to undertake such a risk.

In this sense, the business judgement rule appears to disregard entirely the notion of long- and short-term decision-making. The juxtaposition between long- and short-term risk adoption will always cause conflicting views as to whether a decision was rational or irrational in the given circumstances. Under the current s 180(2), the balance between a short-term risk which returns significant shareholder value and a longer-term, more capital-intensive risk seemingly deters the former and rewards the latter. This is entirely due to the objective nature of the current test, which requires directors to substantially rationalise their decisions according to a prefixed substratum of information. In the absence of such information, it is exceedingly difficult for a director to substantiate that they "informed themselves of the subject matter of the judgement" or that the decision was "rational." Under the current test, a director who undertakes short-term entrepreneurial risks requiring opportunistic responses to dynamic market changes would be unable to substantiate their position regardless of the positive outcome. Such risks fall outside the scope of s 180(2) and deter directors from capitalising on significant environmental changes that, while opportunistic and value-adding, carry too great a legal risk to justify. This is perhaps why the business judgement rule has rarely been the subject of Australian case law.²⁰

Because many business decisions can involve a virtually infinite number of variables and contingencies, the definition of duty of care provided by the Cooney Report can be viewed as falling short of the specificity needed by both directors and shareholders. Some additional specificity can be gained by consulting the primary source of the business judgement rule in Australia today. Pursuant to Section 180 of the Commonwealth Corporations Act 2001, a director or other officer of a corporation who makes a business judgment is assumed to have satisfied the requirements of subsection (1) — and their equivalent duties at common law and in equity — in respect of the judgment, provided they:

1. Make the judgment in good faith for a proper purpose; and

2. Do not have a material personal interest in the subject matter of the judgment; and

3. Inform themselves about the subject matter of the judgment to the extent they reasonably believe to be appropriate; and

4. Rationally believe that the judgment is in the best interests of the corporation. The director's or officer's belief that the judgment is in the best interests of the corporation is a rational one unless the belief is one that no reasonable person in their position would hold.

Therefore, pursuant to their fundamental duty of care, all corporate directors are required to be diligent and prudent in the oversight of the enterprise's affairs. In general, courts will not overturn or second-guess the decisions made by directors provided those decisions are made in good faith, except in those events where the business judgment reached was considered unintelligent or ill-advised and based on inadequate information.²¹ Directors must therefore ensure that, preparatory to making decisions that will affect their companies, they have performed the requisite due diligence needed to inform themselves of all material information reasonably available to them and proceed with a critical eye in assessing corporate information.²²

It is important to note that in this context "prudent" does not necessarily mean "risk-free." Indeed, the argument could be made in some situations that the prudent course of action to maximise shareholder value requires taking significant risks — but such risks are regarded as acceptable if they are firmly based on all material information reasonably available. While it is reasonable to posit that different observers may believe other material information should have been consulted, hindsight is 20-20. Even the most experienced corporate directors are subject to the same limitations shared by all human actors in a dynamic marketplace where circumstances change and unexpected developments alter the apparent reasonableness of a business decision. Keeping corporate directors on tenterhooks by holding a punitive sword of Damocles over their heads — one that inhibits the types of risk-taking and innovation needed to develop and sustain a competitive advantage — is therefore not in the best interests of directors or shareholders.

Balancing Innovation and Corporate Responsibility

Although the precise amount remains unclear, a growing body of research confirms that corporate success is driven by risk-taking and innovation. Research consistently shows that, all else being equal, corporations that engage in risk-taking and innovation enjoy a competitive advantage over their less aggressive counterparts. For example, according to Schmidt and Soper (2013), "An American Management Association (2010) survey identified creativity and innovation as one of the four skills needed for success today and in the future. A recent IBM poll of 1,500 CEOs also identified creativity as the No. 1 leadership competency of the future."²³ Corporations that encourage a certain amount of calculated risk-taking and innovation on the part of their directors are therefore conforming to best industry practices for developing and maintaining a competitive advantage in an increasingly competitive environment. In this regard, Hoque and Walsh (2013) advise that "enterprises have discovered that the management of business allows them to create a sophisticated organising logic to encourage innovation, strategic experiments, and calculated risk taking."²⁴ The term "calculated risk-taking" is especially telling because it directly relates to the business judgement rule: it assumes that all appropriate information and material facts, including consideration of shareholder views, were reviewed in the decision-making process and that the initiative was undertaken in the best interests of the firm.

Although it is virtually impossible to guarantee that every material fact and all relevant information was reviewed as part of the decision-making process, the prevailing definitions applied to the business judgement rule indicate that a line has to be drawn somewhere with respect to adequacy, and directors must be allowed to pursue risks in order to achieve the innovation needed to remain viable. As McCormick (2012) points out, "Without relentless innovation, success will be fleeting. In most organisations innovation happens 'despite the system' rather than because of it. That's a problem because innovation is the only sustainable strategy for creating long-term value."²⁵

Therefore, if innovation is the only sustainable strategy for creating long-term value, shareholders should encourage these behaviours on the part of their corporate directors. This assumption does not mean that directors should be given carte blanche in their risk-taking, but it does mean that it is in the best interests of all stakeholders for corporations to pursue initiatives that will help them grow and sustain a competitive advantage, even when those initiatives involve risks, because the pursuit of such opportunities is a primary responsibility of directors in the first place.

As noted in the introductory chapter, the fallout from the recent failures of high-profile multinational corporations has caused many boards to become more conservative in their risk-taking practices, but this trend has also hampered innovation. Nevertheless, risk-taking and innovation are the keys to corporate survival. To the extent that directors fail to pursue new opportunities and develop innovative practices on an ongoing basis, they may be viewed as having abrogated their fiscal responsibilities to shareholders. As McCormick concludes, "Boards everywhere have battened down the hatches. But despite these stringent financial times, innovation is critical to survival. Our ability to adapt and innovate delivers both progress and prosperity."²⁶

Unfortunately, identifying the appropriate balance between enough and too much risk as applied to a given business decision can be enormously challenging, because all humans view the world through a unique lens based on a lifetime of experiences and personal values that will inevitably affect the analysis. Consequently, while some directors and shareholders may feel they are taking an appropriate amount of risk, others may feel they are not taking enough and are missing important opportunities. Because directors have been invested in their positions by virtue of their purported qualifications and expertise, the balance between too much and too little risk must be viewed in light of the enormous differences that exist between individuals — but with the understanding that directors must be assumed to be acting in the best interests of the company unless or until a preponderance of evidence indicates otherwise.

The freezing effect that existed prior to the implementation of the business judgement rule operated to prevent risk-taking by some corporate directors in ways that adversely affected their competitiveness and profitability. It reduced their willingness to engage in risk-taking ventures that might backfire due to unforeseen circumstances or a perceived lack of due diligence. In this regard, Harris (2009) emphasises that "even those [directors] with a big idea won't succeed without a 'go for it' attitude and a willingness to take risks."²⁷

Conclusion and Recommendations

The research showed that it is reasonable to conclude that at least some of the problems experienced with the application and adjudication of the business judgement rule concern whether such a rule was even needed in the first place. Beyond this issue, there were also a number of other problems cited in the literature concerning the current versions of the business judgement rule in Australian jurisdictions. The current general criteria used to determine whether the rule provides corporate directors with a defence against personal liability were shown to be that decisions must be made in good faith and for a proper purpose, that directors must have acted on an informed basis without material personal interest, and that they must have held a rational belief that the decision was in the best interests of the corporation. Each of these criteria, however, was also shown to be riddled with subjective holes that make the types of predictable outcomes expected in the courts virtually impossible to achieve.

When concepts such as "rational," "best interests," and "good faith" are applied to any issue, the outcome will likely depend on the respective views of the stakeholders involved. Given that corporations frequently comprise tens of thousands of shareholders who may hold vastly divergent views concerning what is in an organisation's best interests, the concepts of good faith and rationality become even cloudier. Complicating the problem is a lack of relevant case law and a paucity of specificity in the controlling legislation. These constraints and limitations underscore the legitimacy of the original question concerning whether Australian jurisdictions need a business judgement rule at all.

Assuming that such a need exists, it is clear that the existing gaps and limitations must be resolved in order to provide the rule with the clout needed to achieve its intended objective of offering a legal defence against personal liability for corporate directors whose business decisions have gone awry — excluding intentional criminal misconduct. Taken to its logical extreme, it is also reasonable to conclude that the chilling effect of having to satisfy all the criteria of the business judgement rule to obtain its protections may discourage many directors from engaging in the very risk-taking activities that form an integral part of their responsibilities to the firm, unless and until these issues are resolved to everyone's satisfaction — an outcome that remains unlikely given the divergent views concerning the rule's necessity.

Other criticisms levelled against the business judgement rule include that it fails to take into account the reality of how corporate boards actually operate and the fundamental differences between corporate directors and other business professionals. The stipulation that courts must apply an objective analysis to an inherently subjective set of criteria makes the predictability of this legal analysis challenging, if not impossible — an outcome contrary to the precepts of common law. While it is also reasonable to conclude that corporate directors require some type of protection against personal liability claims for the rational business decisions they make in the corporation's best interests, the case can be made that the business judgement rule in its current form fails to achieve its intended objectives.

Based on the identified limitations and gaps concerning the business judgement rule in Australian jurisdictions and the numerous criticisms directed at the rule since its enactment, the following recommendations are provided:

First, because the legal community has a vested interest in legislation that promotes litigation, it is recommended that a representative sample of Australian business leaders be surveyed — rather than lawyers — in order to gauge their views concerning the need for a business judgement rule today. If an overwhelming majority of respondents reply in the negative, it is further recommended that Australian policymakers consider repealing this rule.

Second, assuming that a legitimate need is identified for the business judgement rule, the current criteria were shown to be highly subjective and require reformulation in order to provide a consistent and predictable legal analytical framework. It is therefore recommended that quantifiable measures and weights be developed that can be used to consistently evaluate the criteria currently used to determine whether corporate directors should receive protection from personal liability.

Third, and also assuming that a legitimate need is identified for the business judgement rule, it is recommended that a set of best practices based on other countries where the rule has been implemented be developed in order to provide Australian corporate directors with a series of evidence-based steps they can take to maximise the likelihood that their business decisions will satisfy the requirements of the business judgement rule.

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