Practice Tip: The Business Judgment Rule As Applied to Matrimonial Matters

According to Black's Law Dictionary, Sixth Edition, the Business Judgment Rule is described as follows:

This Rule immunizes management from liability in corporate transaction undertaken within both the power of corporation and authority of management where there is reasonable basis to indicate that transaction was made with due care and in good faith.

Nursing Home Bldg. Corp. v. DeHart, 13 Wash. App. 489, 535.

The Business Judgment Rule was first recognized in Otis & Co. v. Pennsylvania R. Co., 61 F.Supp. 905 (DCPA 1945). Otis was a shareholder's derivative action that alleged that the corporate directors did not obtain the best price available for the sale of securities and dealt only with a single investment house. The action alleged that by failing to shop sufficiently for the best price available, the directors cost the company significant money. The court in Otis ruled that although the directors made the wrong decision, their decision was made in good faith. The court determined that “mistakes or errors in the exercise of honest business judgment do not subject the officers and directors to liability for negligence in the discharge of the appointed duties.” In essence, the Business Judgment Rule has been used to protect owners and directors from liability when exercising their duties in good faith.

Indeed, the Rule has been expanded to protect owners and directors in a wide number of cases. Should this rule also be applied to the matrimonial setting?

The Rule Applied in Divorce

In most matrimonial cases, the parties do not trust each other. The non'business-owning spouse questions the actions of the business owning spouse. Were certain actions in good faith? Are they legitimate? Were they done to hide income? Why are we receiving less money from the business now than in previous years? These are all genuine questions raised during the course of a divorce.

Thus, questions always exist regarding whether accumulated cash of a closely held corporation that is not distributed to the owner should be considered part of the marital estate or merely an asset of the business.

This is an important distinction ' for experience shows that a non-owning spouse will usually receive more by way of equitable distribution if considered a personal marital asset than if the accumulated cash is merely part of the business. More specifically, in most jurisdictions, money that exists in joint accounts at the time the complaint for divorce was filed would be shared (for the most part) equally by the parties. If, however, earnings are retained in the business, rather than distributed, the non-owning spouse would almost certainly receive less by way of equitable distribution than an equal split.

Whom Does the Rule Protect?

Does the Business Judgment Rule protect this kind of decision by the business-owning spouse? As mentioned above, the Business Judgment Rule purportedly protects directors from being questioned or second-guessed on conduct of corporate affairs. Certainly, there are exceptions for fraud, self-dealing or unconscionable conduct. It really, however, is not a rule at all as it does not prevent certain kinds of conduct. Instead, it provides a blanket protection to individuals acting in good faith in the best interests of the business. In a divorce case, additional avenues for overcoming the business rule should be evaluated. At the very least, the following questions should be addressed:

• Is there a legitimate financial reason for retaining dollars in the company?
• What is the type of corporation and how many individuals are required to make such a decision? (In other words, does the form of the corporation ( i.e. , a “C” corporation as opposed to a “Subchapter-S” corporation) make a difference?
• Is there a historical precedent for retaining funds in the business?
• What is the nature and degree of control exercised by the spouse in determining whether funds should be retained?
• Are the nature and extent of the business such that retention of dollars is standard in similarly situated businesses?

Evaluating and answering the above questions from both sides of the equation will be instructive in determining whether or not the application of the Business Judgment Rule will protect the business-owning spouse. Indeed, these questions hit at the heart of both the concerns of the individuals deciding to retain earnings and of the potentially aggrieved spouse who would be harmed by treating the retained earnings differently from marital property.

Lawrence J. Cutler, a member of this newsletter's Board of Editors, is of counsel at Laufer, Dalena, Cadicina, Jensen & Boyd, LLC, Morristown, NJ. Gregory D.R. Behringer is an Associate at the firm.

According to Black's Law Dictionary, Sixth Edition, the Business Judgment Rule is described as follows:

This Rule immunizes management from liability in corporate transaction undertaken within both the power of corporation and authority of management where there is reasonable basis to indicate that transaction was made with due care and in good faith.

Nursing Home Bldg. Corp. v. DeHart , 13 Wash. App. 489, 535.

The Business Judgment Rule was first recognized in Otis & Co. v. Pennsylvania R. Co. , 61 F.Supp. 905 (DCPA 1945). Otis was a shareholder's derivative action that alleged that the corporate directors did not obtain the best price available for the sale of securities and dealt only with a single investment house. The action alleged that by failing to shop sufficiently for the best price available, the directors cost the company significant money. The court in Otis ruled that although the directors made the wrong decision, their decision was made in good faith. The court determined that “mistakes or errors in the exercise of honest business judgment do not subject the officers and directors to liability for negligence in the discharge of the appointed duties.” In essence, the Business Judgment Rule has been used to protect owners and directors from liability when exercising their duties in good faith.

Indeed, the Rule has been expanded to protect owners and directors in a wide number of cases. Should this rule also be applied to the matrimonial setting?

The Rule Applied in Divorce

In most matrimonial cases, the parties do not trust each other. The non'business-owning spouse questions the actions of the business owning spouse. Were certain actions in good faith? Are they legitimate? Were they done to hide income? Why are we receiving less money from the business now than in previous years? These are all genuine questions raised during the course of a divorce.

Thus, questions always exist regarding whether accumulated cash of a closely held corporation that is not distributed to the owner should be considered part of the marital estate or merely an asset of the business.

This is an important distinction ' for experience shows that a non-owning spouse will usually receive more by way of equitable distribution if considered a personal marital asset than if the accumulated cash is merely part of the business. More specifically, in most jurisdictions, money that exists in joint accounts at the time the complaint for divorce was filed would be shared (for the most part) equally by the parties. If, however, earnings are retained in the business, rather than distributed, the non-owning spouse would almost certainly receive less by way of equitable distribution than an equal split.

Whom Does the Rule Protect?

Does the Business Judgment Rule protect this kind of decision by the business-owning spouse? As mentioned above, the Business Judgment Rule purportedly protects directors from being questioned or second-guessed on conduct of corporate affairs. Certainly, there are exceptions for fraud, self-dealing or unconscionable conduct. It really, however, is not a rule at all as it does not prevent certain kinds of conduct. Instead, it provides a blanket protection to individuals acting in good faith in the best interests of the business. In a divorce case, additional avenues for overcoming the business rule should be evaluated. At the very least, the following questions should be addressed:

• Is there a legitimate financial reason for retaining dollars in the company?
• What is the type of corporation and how many individuals are required to make such a decision? (In other words, does the form of the corporation ( i.e. , a “C” corporation as opposed to a “Subchapter-S” corporation) make a difference?
• Is there a historical precedent for retaining funds in the business?
• What is the nature and degree of control exercised by the spouse in determining whether funds should be retained?
• Are the nature and extent of the business such that retention of dollars is standard in similarly situated businesses?

Evaluating and answering the above questions from both sides of the equation will be instructive in determining whether or not the application of the Business Judgment Rule will protect the business-owning spouse. Indeed, these questions hit at the heart of both the concerns of the individuals deciding to retain earnings and of the potentially aggrieved spouse who would be harmed by treating the retained earnings differently from marital property.

Lawrence J. Cutler, a member of this newsletter's Board of Editors, is of counsel at Laufer, Dalena, Cadicina, Jensen & Boyd, LLC, Morristown, NJ. Gregory D.R. Behringer is an Associate at the firm.