What is the Business Judgment Rule?
The Business Judgment Rule is a legal presumption evolved by Delaware courts. It was thereafter adopted by most commonwealth countries. The presumption is that while making business decisions, Directors of a company act in good faith, on an informed basis and in the honest belief that the action is in the best interest of the company. If the above conditions are satisfied, the Board of Directors will not suffer a legal liability from a bad business decision. The rationale being that in an inherently risky global business environment, the Board should be allowed to take business risks without the constant fear of lawsuits.
In the celebrated case of Aronson v. Lewis, the Delaware Supreme Court was of the view that:
“The business judgment rule is an acknowledgment of the managerial prerogatives of Delaware directors under Section 141(a). It is a presumption that in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.”[1]
The BJR as developed by the Delaware courts has been applied and adopted by the superior courts of most commonwealth countries. In fact, South Africa[2] and Australia[3] have codified the Business Judgment Rule in their respective company law statutes.
Legal position in India:
Unlike the West, India’s superior judiciary has so far not pronounced any verdict on the applicability of the Business Judgment Rule for bad commercial decisions made by Directors. The extent to which the courts might refrain from intervening in commercial decisions taken in good faith is still unclear. The lack of jurisprudence on this subject in India could partly be because India does not have the tradition of filing derivative class action lawsuits against Directors for breach of their duties on account of a multitude of factors, including endemic delays associated with the Indian judicial system, absence of Plaintiff’s bar and prohibition in Indian law on “success fee-based” litigation. Further, the concept of “punitive damages” is not permissible under Indian law. Therefore, even though a specific provision was introduced under Section 245 of the Companies Act 2013 (“Act”) for class action lawsuits since April 1, 2014, activist groups of shareholders have refrained from filing any class action lawsuit.
The closest that the Supreme Court has opined is in the celebrated Miheer H Mafatlal v. Mafatlal Industries case, wherein it was held that the court would not interfere when the Director’s conduct was “just, fair and reasonable, according to a reasonable businessman, taking a commercial decision beneficial to the company”.[4]
This judgement is helpful to Directors if they can demonstrate that they acted diligently for the larger corporate purpose in good faith and personal interests didn’t play a part. Similarly, in Needle Industries (India) v. Needle Industries Newey (India) Holding Ltd.[5], the Supreme Court upheld the decision of the Board of Directors to make a rights issue of equity shares, as the company needed funds and the decision was taken for the larger corporate purpose.
While there is no explicit mention of the Business Judgment Rule, the same principles have been applied while upholding the validity of the rights issue. Indian courts have recognised that the Directors’ decision-making process is complex, and various factors[6] need to be considered. Some sections of the legal fraternity believe that the courts in India may be reluctant to apply this doctrine in the way it is applied by Delaware courts for fear that it may give too much flexibility in the hands of Directors specifically and corporates more generally.
Business Decisions where this rule can be applied:
Section 179 of the Act provides that the Board of Directors of a company shall be entitled to exercise all such powers, and do all such acts and things, as the company is authorised to exercise and do. So, the Indian Company law empowers the Board of Directors to take all decisions, except those that require prior shareholder approval and in some rare cases, of the central government.
The Boards of Indian companies have made several business decisions such as large cross border acquisitions, many of them are leveraged buyout structures, divestments of major operating divisions of the company, mergers and demergers, diversification into unrelated line of business activity , major green field projects/investment decisions, some of which have gone terribly wrong. Luckily for the Indian Boards, shareholders of such companies have not filed any derivative suits against the Directors for breach of their fiduciary duties though such decisions have caused huge financial losses, with some being (appearing) rather reckless.
The Burden of Proof in such cases:
The initial burden of proof will obviously be on the plaintiff to establish that:
- There was breach of duty by the Director,
- The loss caused to the plaintiff was foreseeable, and
- The Directors that caused such a loss had taken the decision mala fide and it was not in the best interest of the company, and there was a conflict of interest on the Directors’ part in the said business decision.
The Supreme Court has also clarified that where the duties are imposed by a statute, a mere breach of statutory duty could be proof enough of negligence and the wrongdoer Director cannot argue ‘unforeseeable harm’ since the very object of the legislation is to put that particular precaution beyond controversy.[7] The Director who wants to seek immunity under Section 149(12) will need to demonstrate that he had discharged all his duties articulated under Section 166 of the Act. Once the Directors can demonstrate diligence, zero conflict of interest and prove that the business decision was taken for the larger corporate purpose, the courts may be willing to grant immunity to such Directors.
Should Indian parliament Codify the Business Judgment Rule?
This leads us to a larger legislative policy question – whether Indian parliament should specifically codify Business Judgment Rule in company law, akin to Directors’ duties under Section 166 of the Act. With the enactment of Section 245 of the Act providing for class action lawsuits, rise of proxy advisory firms and the activist role played by them, and the SEBI adopting a zero-tolerance policy towards Directors’ negligence in performance of their duties, it may be worth considering bringing this rule, at least for business decisions by the Boards of listed companies.
Indian Parliament has come out with an Indianised version of the Business Judgment Rule under Section 463 of the Act, which provides that a Director can get relief from the courts in any proceedings for negligence, default, breach of duty, misfeasance or breach of trust if he can demonstrate that he had acted honestly and reasonably. Under such circumstances, the court may relieve him, either wholly or partly on such terms as it may think fit. However, this provision is not an effective substitute for the business judgment rule.
For independent and non-executive directors, (not being promoters or key managerial personnel), Section 149(12) of the Act grants only limited immunity for acts of omission or commission, if it occurs without their knowledge, consent or connivance as can be determined through the Board processes, implying that such Directors had acted diligently. Therefore, there is a strong case to introduce the Business Judgment Rule through an appropriate amendment to the Companies Act, incorporating the cardinal rules laid down by Delaware courts.
The next question is, should the rule be uniformly applied for Executive Directors like Managing Directors and Whole Time Directors, Promoter Nominees as against Non-Executive Directors and Independent Directors who have a limited role to play in the day-to-day affairs of the company. The problem is compounded by the fact that the lower Indian judiciary has not been making any distinction between Executive and Non-Executive Directors, including Independent Directors, and invariably the process under Section 204 of the Code of Criminal Procedure, 1973, is issued against all Directors, irrespective of the degree of involvement in the business decisions of the company. There are authoritative pronouncements of the Supreme Court that hold that such Non-Executive Directors cannot be prosecuted for an offence under Section 138 of the Negotiable Instruments Act, in cheque bouncing cases. Unfortunately, Directors have to go through criminal trial or seek intervention of High Courts under Section 482 of Code of Criminal Procedure, 1973, to get the prosecution quashed. In criminal trials in India, the process itself is a punishment and ultimate acquittal or discharge by a higher judiciary is no reprieve for the harassment such directors have to undergo till the time the prosecution against them is quashed.
Consequently, senior professionals, who would have been able to add much value to the quality of Board deliberations and decision making, are now reluctant to join corporate Boards. Hence, there is a strong case for Indian parliament to consider codifying this rule. The business environment and the regulatory architecture in the country has become complex. Regulators are becoming enforcement focused and law enforcement agencies are becoming prosecution focused. There is no guarantee that every Board decision will prove beneficial to the company in the long term. Board of Directors of companies will have to take certain risky decisions from time to time as an overly cautious approach could lead to considerable opportunity loss. The Boards need to be provided with an effective safe harbor for bona fide business decisions where there is no conflict of interest and are taken for the larger corporate purpose. Various safeguards can be incorporated while codifying the rule.
Codifying this rule in our law will work wonders for the Government of India’s broader philosophy of creating a legal environment which facilitates ease of doing business in the country.
[1] Aronson v. Lewis, 473 A.2d 805 (1984).
[2] Section 76(4), South Africa Companies Act, 2008.
[3] Section 180(2), Australia’s Corporations Act, 2001.
[4] (1997) 1 SCC 579.
[5] (1981) 3 SCC 333.
[6] Tata Consultancy Services Ltd. v. Cyrus Investments Pvt. Ltd. and Ors., (2021) 9 SCC 449.
[7] Sushil Ansal v. State through Central Bureau of Investigation, (2014) 6 SCC 173.
