Precedent Set: ‘Business Judgment Rule’ Also Applies to a Board Resolution on Filing a Derivative Suit

The Israeli Supreme Court has set a precedent by ruling that the Business Judgment Rule should also be applied to a company’s board of directors when it is deciding whether or not to file a derivative suit.

A derivative suit enables directors and shareholders to file an action on behalf of the company (in respect of a cause of action of the company) against an officer, a controlling shareholder, or an external party.

According to the mechanism prescribed in the Companies Law, the right to file a derivative suit is not automatic. The plaintiff (a shareholder or director) is required to first demand that the company fully exercise its rights by way of filing an action addressing the relevant matter. If the company is not prepared to file a lawsuit, then the plaintiff must obtain the court’s approval to file the lawsuit as a derivative suit.

The court will not approve a derivative suit unless the following three preconditions are met: (1) the company has sufficient cause of action; (2) the lawsuit and the conduct thereof are in the company’s best interests; and (3) the plaintiff is not acting with mala fides.

If the court approves the filing of the derivative suit, then the suit is conducted by that shareholder or director (the plaintiff), on behalf of the company.

Before handing down its ruling, the Supreme Court deliberated the question of whether and to what extent the court should intervene in the judgment of a company’s board of directors when it decides not to file a derivative suit against a third party. The backdrop to this issue is another question: does such a board decision warrant protection under the Business Judgment Rule?

The Business Judgment Rule prescribes that a board resolution passed during a proper proceeding be afforded immunity from judicial scrutiny. The court will not examine a board of directors’ use of judgment, provided that the resolution was passed without there being any conflicts of interest, after the board analyzed the data and considered the relevant considerations, and provided that the resolution was passed with bona fides (subjectively).

The Supreme Court set the precedent by ruling that a company’s decision not to file a lawsuit is a business decision like any other business decision, which includes various considerations about whether “a lawsuit and the conduct thereof would benefit the company.”

The Supreme Court referred to the following considerations: (1) an assessment of the prospects of winning the lawsuit (and for this purpose, the Supreme Court stated that legal advice should be received in order to make an informed decision); (2) the financial cost of conducting the lawsuit compared to the potential award if the company were to win the lawsuit; and (3) additional repercussions, such as the effect on business relations, damage to the company’s reputation, etc.

In its ruling, the Supreme Court determined that there is no preclusion to applying the Business Judgment Rule to the company’s decision not to file a derivative suit—thereby, in effect, limiting judicial intervention in decisions of this type. Further, it held that the board of directors be allowed to exercise its own judgment about whether to accede to the shareholder or director’s demand that the company file a lawsuit.