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The business judgment rule – risk versus reward

The business judgment rule – risk versus reward

Hoda Nahlous discusses the balance of risk versus reward in business.

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Director, KPMG Law

KPMG Australia

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In this current environment that is leaning towards a 'compliance-focused' leadership, the appetite and scope for directors to in fact take risks is in question. However, effective leadership must involve a degree of reasonable risk taking in order to encourage entrepreneurial decision-making.

Those entrusted with the position of directors must be confident that they may continue to balance organisational risk versus reward – this is the fundamental role of directors.

It would not serve the interests of stakeholders if Board deliberations were heavily swayed towards a compliance-focused outcome, inducing a growth and opportunity paralysis.

'Risk' is owned by the Board

Consistent with the ASX Principles and Recommendations, a Board charter for a listed (and often unlisted) entity is commonly prefaced with the commanding statement that the role of the Board is to provide leadership and set the strategic objectives of the entity. In this regard, the Board must determine the appropriate degree of risk that the entity can operate within as part of the pursuit to achieve these strategic objectives. Whether or not the entity has a risk committee (and if so, whether consolidated with, or separate to, an audit committee), it is the Board that ultimately wears the responsibly for risk. In this regard, the Board must satisfy itself that risk policies and procedures that are implemented and effected by senior executives of the entity are consistent with and give voice to the entity’s strategy and risk appetite.

A Board’s decision to pursue a particular objective may at times result in an almost uncomfortable degree of loss. Even so, this does not mean that there was a dereliction of duty by the Board in forming its views, at that time, that the potential rewards outweighed the potential risk of harm to the entity. In this regard, the case law is clear: Boards must be permitted to exercise reasonable risk-taking; and, in determining what is 'reasonable risk-taking' emphasis cannot be placed too heavily on the benefit of hindsight.

The business judgment rule

The statutory business judgment rule in Section 180(2) of the Corporations Act 2001 (Cth) (Act) stills serves its purpose as the safe-harbour it was intended to be, providing directors with greater protection in respect of bona fide decisions.

Specifically, the statutory business judgment rule provides that a director is taken to have exercised their powers with the necessary degree of care and diligence (for the purposes of Section 180(1) of the Act) if they made a 'business judgment'. This requires the director to act in good faith and for a proper purpose, to not have a material personal interest in the subject matter at hand, be informed about the subject matter to the degree determined reasonably appropriate, and hold the belief that the judgment is in the best interests of the entity.

The statutory business judgment rule does not serve to reduce the level of director accountability, but ensures that directors are not liable for decisions made in good faith and with due care. The intention of the business judgment rule was to provide certainty to directors in terms of their liability as the rule encourages directors to take advantage of business opportunities and not behave in an unnecessarily risk averse manner.

In applying the statutory business judgment rule the Courts have rightly acknowledged that when the Australian Securities and Investments Commission second-guesses a Board’s business judgment with the benefit of hindsight, it is a process which is divorced from the reality of the speed at which the events occurred in real time. Just as importantly, such assessment must not only focus on the potential risks and downsides but also the potential benefits (even if these benefits are not realised) – this is the framework in which the business judgment must be analysed.

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