Business Unusual: Recent Applications of New York’s Business Judgment Rule

The business judgment rule is a longstanding principle of New York law that presumes a company’s directors and officers are in a better position than courts to make business decisions even if, with the benefit of hindsight, their judgment proves to be mistaken.  See Auerbach v. Bennett, 47 N.Y.2d 619, 629 (1979).  But this doctrine does not grant directors and officers unfettered impunity, and the business judgment rule will not apply to egregious decisions that sound in fraud, self-interest, or bad faith.  See Lippman v. Shaffer, 15 Misc. 3d 705, 711 (Sup. Ct. Monroe Cnty. 2006) (“A plaintiff may overcome the presumption of the business judgment rule, inter alia, by demonstrating that ‘no person of ordinary sound business judgment would say that the corporation received fair benefit.'” (citation omitted)).

This article examines recent decisions by New York courts at various stages of litigation that reviewed allegations of self-dealing or self-interest on the part of defendants.  Although the business judgment rule provides broad protections, it is not absolute and can be overcome when directors’ actions fall outside of the bounds of acceptable corporate behavior.

Courts applying New York law are loathe to interfere in business decisions (whether taken through affirmative acts or omissions) when they are made in good faith, with due care, and in the best interests of the corporation.  See In re Kenneth Cole Prods., Inc., 27 N.Y.3d 268, 274 (2016) (“[W]e have long adhered to the business judgment rule….on a recognition that[] courts are ill equipped to evaluate what are essentially business judgments; there is no objective standard by which to measure the correctness of many corporate decisions (which involve the weighing of various considerations); and corporate directors are charged with the authority to make those decisions.”); see also Max v. ALP, Inc., 203 A.D.3d 580, 582 (2022) (dismissing claims of breach of fiduciary duty and corporate waste because the allegations were insufficient to overcome the “powerful presumptions of the business judgment rule” (citation omitted)). 

The Commercial Division’s recent decision in Palella v. TMO VI LLC, provides a useful illustration of the protection that the business judgment rule can provide, even at the motion to dismiss stage.  No. 655556/2023, 2024 N.Y. Slip Op. 32933(U), at *2 (Sup. Ct. N.Y. Cnty. Aug. 19, 2024).  Directors may be considered self-interested when they receive a direct financial benefit from the transaction that is different from the benefit to shareholders generally.  See Hunzinger v. Plaid Inc., Nos. 652578/2012, 653086/2012, 2018 N.Y. Slip Op. 30098(U), at *7‑8 (Sup. Ct. N.Y. Cnty. Jan. 18, 2018) (“[T]he business judgment rule does not apply to Ms. Costello’s plainly self-interested determination[s] to increase her own salary,” “relocat[e] to and renovat[e] a new office space, engag[e] Ms. Costello’s husband as a consultant, and discontinu[e] [the company’s] policy of making profit distributions.”).

Palella involved a dispute in which the board of directors opted to enter into a management agreement for the operation of a parking garage rather than exercising an option for a new 49-year lease.  Palella, 2024 N.Y. Slip Op. 32933(U), at *3.  The shareholder plaintiffs alleged that the board’s decision was detrimental and reflected poor judgment because the lease would have been more profitable in the long run.  Id.  But without specific allegations of self-dealing or bad faith, the court relied on the business judgment rule in dismissing the plaintiffs’ claims.  Id.

The pleadings did not suggest that the board acted in its own interest or engaged in any improper conduct.  Given the uncertain economic conditions resulting from the COVID-19 pandemic, the board opted for a safer, guaranteed revenue stream rather than the potential financial risk associated with a long-term lease.  Id.

The court held this was a reasonable justification for the directors’ actions.  Notably for defendants, the court also reinforced that merely alleging that a different course of action might have been more profitable is insufficient to overcome the presumption of the business judgment rule.  Id.

The Palella decision reaffirms that a plaintiff must clear a high bar to rebut the presumption of the protection of the business judgment rule.  But this bar is not insurmountable, and another recent decision from the Commercial Division provides a counterexample where a plaintiff has been able to clear it.

For example, unlike Justice Melissa Crane in Palella, Justice Margaret Chan denied a motion to dismiss, holding that “pre-discovery dismissal of pleadings in the name of the business judgment rule is inappropriate where those pleadings suggest[] that the directors did not act in good faith.”  Agarwal v. Jain, No. 650333/2024, 2024 N.Y. Slip Op. 32492(U), at *5 (N.Y. Sup. Ct. July 12, 2024) (citation omitted) (emphasis added).

Justice Chan held that the allegations “smack[ed] of bad faith” where the plaintiff alleged that the defendants conspired to provide “sweetheart” arrangements to competitors in order to reduce dividends after a failed attempt to reorganize the parties’ operating agreement.  Id.  In that instance, the allegations were beyond acceptable business practices such that the plaintiff was able to overcome the protections of the business judgment rule and proceed to discovery.  Id.

Courts facing the question of whether the presumption should apply at later stages of litigation will scrutinize the facts carefully and have ruled that evidence of self-dealing can preclude the presumption.

In Gallagher v. Crotty, the trial court denied defendants’ motion for summary judgment on the basis that the business judgment rule did not apply because the defendant directors had amended certain LLC operating agreements, which affected a plaintiff’s distribution rights to management fees, without his consent.  This “obviously conflicted” compensation raised concerns of self-dealing and barred the protections of the business judgment rule.  Gallagher v. Crotty, No. 651498/2015, 2023 WL 3203585, at *5 (Sup. Ct. N.Y. Cnty. May 02, 2023).  The First Department affirmed the trial court’s decision.  226 A.D.3d 426 (1st Dept. 2024).

In Kleeberg v. Eber, Judge Lewis Kaplan of the Southern District of New York, after a bench trial applying New York law, also declined to apply the business judgment rule because the challenged transactions were “tainted by self interest.”  665 F. Supp. 3d 543, 600 (S.D.N.Y. 2023).  There, the defendant used a sham entity to acquire an interest in another entity where she served as an officer.  Id. at 599‑01.  In the face of that blatantly improper behavior, the court set aside the presumption of the business judgment rule and evaluated the entire fairness of the transaction.  Id. at 600.

In sum, the business judgment rule remains a powerful tool to shield directors from undue judicial scrutiny, recognizing that business decisions often require risk-taking and professional expertise that the courts lack.  Despite its significant defense of directors and officers against the second guessing of their management decisions, it does not provide absolute immunity.

Plaintiffs who can allege plausible conflicts of interest or self-dealing may be able to evade the substantial protection that it can provide to defendants.  As always, corporate directors and officers should ensure that their decisions are well-documented, informed, and made to benefit the company rather than for their own personal gain.

Lara Flath is a complex litigation and trials partner in Skadden, Arps, Slate, Meagher & Flom. Jacob Fargo and Gaby Colvin are complex litigation and trials associates at the firm.