Reference no: EM133298184

Case: The appellees-directors herein claim that they are protected by the presumption of good faith and fair dealing that arises from the business judgment and, therefore, they do not have the burden of proving that their decision to purchase CSC was intrinsically fair to the Browns' minority shareholders.

The issue before us, then, centers on the applicability of the business judgment rule. The business judgment rule is a principle of corporate governance that has been part of the common law for at least one hundred fifty years. It has traditionally operated as a shield to protect directors from liability for their decisions. If the directors are entitled to the protection of the rule, then the courts should not interfere with or second-guess their decisions. If the directors are not entitled to the protection of the rule then the courts scrutinize the decision as to its intrinsic fairness to the corporation and the corporation's minority shareholders. A party challenging a board of directors' decision bears the burden of rebutting the presumption that the decision was a proper exercise of the business judgment of the board.

In a stockholders' derivative action challenging the fairness of a transaction approved by a majority of directors of a corporation a director must be (1) disinterested, (2) independent, and (3) informed in order to claim benefit of the business judgment rule. If a director fails to pass muster as to any one of these three, he is not entitled to the business judgment presumption. This does not mean that the director's decision is necessarily wrong; it only removes the protection provided by the business judgment presumption. Once this presumption is removed, the court must then inquire into the fairness of the director's decision.

(A) [A] director is interested if (1) he appears on both sides of the transaction or (2) he has or expects to derive a personal financial benefit not equally received by the stockholders; (B) a director is independent if his decision is based on the corporate merits of the subject before the board rather than extraneous considerations or influences; a director is not independent when he is dominated by or beholden to another person through personal or other relationship; and (C) a director is informed if he makes a reasonable effort to become familiar with the relevant and reasonably available facts prior to making a business judgment.

Browns' directors Modell, Gries, Bailey, Berick, Cole, and Wallack, were all stockholders in CSC. Modell was the fifty-three percent majority stockholder in the Browns and the eighty percent majority stockholder in CSC (one hundred percent after March 2, 1982). [These facts convinced the court that the directors were interested in the challenged decision and were therefore not entitled to the protection of the business judgment rule. The court then went on to apply the fairness rule to the purchase of CSC by the Browns.]

(W)hen the transaction "... involves insiders dealing with their corporation the test of validity of the transaction is fairness. That our courts have frequently so held is without question ... the substance of our decisions that 'when the persons, be they stockholders or directors, who control the making of a transaction and the fixing of its terms, are on both sides, then the presumption and deference to sound business judgment are no longer present.'

In the instant case, no arms length negotiations as to price, terms, the elements to be included (or not to be included), or any other aspect of the proposed acquisition ever took place between the Browns and CSC. The $6,000,000 price was arrived at by Messrs. AMA (Modell), Bailey and Poplar ... prior to any disclosure to plaintiffs of the possibility of such an acquisition, and never changed despite plaintiff's objections and despite the valuations furnished the defendants by plaintiffs. The manner in which the subject transaction was initiated, structured and disclosed to plaintiffs therefore did not satisfy the reasonable concept of fair dealing.

The judgment of the court of appeals is reversed, and the judgment of the trial court is reinstated.

Judgment reversed.

Question: When the business judgment rule cannot be used, as occurred in this case, what standard is applied by the court to determine whether to reverse a challenged decision made by the directors?