The Caremark standard and the business judgment rule
Changes in the marketplace, along with changes in society, are forcing boards, managers, regulators and the courts to revisit past legislation and its relevance in today's society. Two of the main standards by which boards are judged are the Caremark standard and the business judgment rule.
Public and private boards have to make many decisions about financial performance. They also make disclosures to shareholders and stakeholders in the interest of transparency. Besides the financial side of business, boards also make many decisions that are unrelated to financial performance and those issues can have negative consequences as well.
Many of the non-financial decisions that boards face today are driven by important social, cultural and political concerns. Most recently, the #MeToo movement and the controversies over the pledge of allegiance and the national anthem have made important headlines that affect most companies in one form or another. Some other current issues that cause today's corporations to evaluate the board's performance include:
- Pay equity
- Immigration and the labor markets
- Trade policy
- Climate change and sustainability
- Manufacture and distribution of guns and opioids
- Corporate finance and politics
- Privacy regulation for social media
- Executive pay ratio
- Cybersecurity
- Free speech
Many states follow the Delaware court decisions, many of which are rooted in the Caremark standard and the business judgment rule, in evaluating whether board directors have fulfilled their duty of care and other fiduciary duties when allegations of poor judgment arise. Recent major issues affecting corporations raise the question of how relevant the Caremark standard and the business judgment rule are as they pertain to today's business and social, political and cultural issues.
What is the Caremark standard?
The history of the Caremark standard stems from the failure of Caremark International, a leading provider of alternative healthcare supplies and services, to comply with laws related to inducements to prescribe drugs. In a lawsuit, the plaintiffs alleged that board directors for Caremark failed to address risks and so breached their duty of care. As a result of this landmark case, the Caremark standard stands as the legal standard of culpability when deciding whether board directors have failed to address a risk. It has historically been difficult to win a challenge based on the Caremark standard.
The central question around the Caremark standard is whether the central claim made warrants legal consideration of whether the board of directors sufficiently supervised and monitored the company's performance.
The outcome of the case determined that when board directors exercise a good faith effort to be informed and to exercise judgment, they fully satisfy the duty of attention. Cases that came after the Caremark standard evaluated director actions based upon whether the director's efforts were flawed or inadequate, and whether there was a blatant disregard of their board director obligations. In other words, courts considered the board's decision to act as well as whether they made a conscious decision not to act in evaluating board director actions.
The reason that the Caremark standard has bearing today is that some board members may be inclined to discount political, social and cultural matters because they aren't primarily business or financial issues. On the whole, corporations have viewed the risk of liability under the Caremark standard under a compliance lens. Corporations that take this view often rely on having a well-designed compliance function to ensure that red-flagged issues will be sure to come to their attention.
One vein of thought is that the responsibility for new and difficult issues should lie primarily with management, since they are the driving forces behind corporate action. Often, when the Caremark standard is being considered, the business judgment rule gets highlighted as well.
What is the business judgment rule definition?
The business judgment rule sets up a framework to assess affirmative board decisions unless a court deems that a more substantial review is warranted. The business judgment rule definition creates a strong presumption that favors corporate board directors. This assumption frees board directors from the potential for liability for decisions they make that don't result in harm to the corporation. The overall assumption is that in cases where there are no indications of direct self-interest or self-dealing, board directors act on an informed basis, and they make decisions honestly and in good faith that their decisions are in the corporation's best interests. The idea behind the business judgment rule definition is to ensure that board directors won't suffer legal action simply because they made a poor decision.
The business judgment rule comes into play for lawsuits where a corporate director takes an action that affects the corporation and a plaintiff sues under allegations that the corporate director violated the duty of care. Courts apply the business judgment rule in such cases and will uphold the director's decisions as long as the director made the decision in good faith, gave it the same care that a reasonably prudent person would give it, and the director acted in the best interests of the corporation. Because the business judgment rule is a presumption in favor of the board, it is sometimes also referred to as the "business judgment presumption."
Final thoughts on the Caremark standard and the business judgment rule definition
Today's divisive issues are very different than the issues that brought the Caremark standard and the business judgment rule into being. It could be time to update laws concerning board director actions and liability.
As long as courts continue to apply the Caremark standard and the business judgment rule, board directors should be certain that they understand what both mean and that they minimally meet the Caremark standard as it pertains to the #MeToo movement and other current-day issues. In particular, board directors should ensure that they have a reliable system that directs information and red flag problems directly to the board's attention. Any forthcoming laws would likely be motivated by a different moral compass than what corporations have faced before the Caremark standard went into effect. Future change would likely arise from one or more of the social, cultural or political issues that are facing today's businesses.
