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Home > Corporate Governance Checklists > Sound Business Judgment and Immunity from Liability

Corporate Governance Checklists

Sound Business Judgment and Immunity from Liability


Checklist Description

This checklist outlines sound business judgment and immunity from liability.

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Definition

Sound business judgment and immunity from liability is a legal principle under common law that makes directors, officers, managers, and other representatives of a firm immune from responsibility for losses acquired in dealings that are within their competences to make when there is satisfactory evidence to demonstrate that the actions were made in “good faith.” The ruling originated in the United States in 1945 and functions by application of precedent, because it is not enacted in legislation.

This judgment allows for a strong presumption of immunity in favor of the board of directors of a business, liberating its members from possible liability for decisions that result in harm or damage to the business. The presumption is that “in making business decisions not involving direct self-interest or self-dealing, corporate directors act on an informed basis, in good faith, and in the honest belief that their actions are in the corporation’s best interest.”

The directors and managers of a business have the responsibility to run and direct the business. Frequently they face difficult decisions, such as purchasing another business or property, expanding into other areas of industry, or issuing shares or paying dividends. To face these tasks without fear of liability, courts have given substantial leeway to directors and managers. As part of their duty of care, directors and managers have a duty not to misuse the business’s assets by undercharging or overpaying for goods and services.

The 1945 ruling specifies that courts will not assess the business decisions of directors who have performed their duties:

  • in good faith;

  • with all the due care that an ordinarily prudent person in a similar situation would exercise under comparable circumstances;

  • in a manner which the directors reasonably believe to be in the best interests of the corporation.

The sound business judgment and immunity from liability rule is very tricky to overturn and the courts will generally not interfere unless there is incontrovertible evidence of fraud or misappropriation.

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Advantages

  • Business decisions must sometimes be made, with high stakes and under considerable time pressure, in circumstances in which detailed information is not available.

  • Sound business judgment and immunity promote optimal corporate governance without compromising directors’ flexibility and innovation.

  • The ruling protects honest directors and officers from the risks inherent when unsuccessful decisions are reviewed in hindsight.

  • It prevents the stifling of risk taking and enterprising business activity.

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Disadvantages

  • The principle gives directors and managers substantial leeway and absolves part of their ethical concern for the management of the business.

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Action Checklist

  • Check to see how the principle of sound business judgment and immunity from liability functions in your country or jurisdiction before relying on it to avoid prosecution.

  • Review risks periodically in the light of strategic objectives. Analyze the risks your business may be facing, their probability, and their likely impact.

  • Seek the advice of specialist legal and risk consultants, who can help you to understand and evaluate complex risks and potential pitfalls.

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Dos and Don’ts

Do

  • Set up an effective and independent corporate governance program to help keep management informed of the constantly changing business environment and its risks.

Don’t

  • Don’t rely on demonstrating “good faith” in sound business judgment to give you immunity from liability.

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Further reading

Books:

  • Emerson, Robert W. Business Law. 5th ed. Hauppauge, NY: Barron’s Educational Series, 2009.
  • Kelly, David, Ruth Hayward, Ruby Hammer, and John Hendy. Business Law. 6th ed. Abingdon, UK: Routledge, 2011.
  • Marsh, Stanley Bryan, and J. Soulsby. Business Law. 8th ed. Cheltenham, UK: Nelson Thornes, 2002.

Websites:

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