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The Business Judgment Rule: Limited Protection For Corporate Decision Makers

Previously, I blogged about the “standing” requirements that must be satisfied if a shareholder or member of a corporation or other entity, like an LLC, wants to sue its officers, director or managers for mis- or malfeasance. That blog described the requirement for court certification that a plaintiff in such a derivative action adequately represents all other shareholders or members. A related issue is how Pennsylvania’s courts apply the “business judgment rule” and how this interacts with Pennsylvania’s pleading requirements.

The business judgment rule limits courts in second-guessing corporate decisions. Like any such protection, it must be designed to protect others from abuse of the discretion it provides. The Pennsylvania Supreme Court, in Cuker v. Mikalauskas, 692 A.2d 1042, 1045 (Pa. 1997), indicated that a corporate officer will not be liable for the consequences of his or her decision if:

– It was a business decision, and;

– done in good faith, and;

– the corporate official had no personal interest in the outcome, and;

– he or she was informed about the decision to the extent they reasonably believed was appropriate under the circumstances, and;

– he or she rationally believed it to be in the best interests of the corporation.

One need only look at the qualifiers and modifiers in that paragraph to conclude that the protections of the business judgment rule can be very limited. This is particularly true when one considers Pennsylvania’s pleading and motion standards. Therefore, while the business judgment rule may protect a corporate officer from liability, it will not necessarily protect him or her from lawsuits.

Pennsylvania’s courts, while stricter than the federal courts, give a plaintiff a great deal of latitude when asserting claims. A plaintiff only has to plead facts sufficient to place a corporate defendant on notice of the claims against which he must defend. These facts can sometimes be pleaded “on information and belief” that is, the plaintiff’s personal belief about what may have occurred. Finally, there is a judicial preference in favor of rejecting initial challenges to claims; courts prefer to let the parties go through discovery to collect evidence before claims are dismissed. If a claim requires proof of many facts and subjective conditions, it is more likely to proceed to litigation.

In conclusion, although the business judgment rule may protect an officer or director from ultimate liability, it does not necessarily protect him or her from the time and cost of the litigation necessary to establish whether that rule’s protections apply. Even if a corporate officer or director acted in good faith without personal interest and with sufficient information, he or she could still have to pay significant legal fees.

What can business owners, entrepreneurs and lawyers do about this exposure? When forming a corporation, the founders should consider whether the entity should indemnify, that is compensate, the officer or director for legal fees and other litigation-related costs. They should also be aware of the provisions of Pennsylvania’s Business Corporation Law that address indemnification of corporate officers and directors: under some circumstances indemnification is mandatory; under other circumstances, it is prohibited. Finally, parties who serve in these capacities should know whether they are indemnified and the extent of that indemnification.

A subsequent blog will address the law of indemnification of corporate officers. If you have any questions about these topics, please contact us.

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