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Posted: September 26, 2018

Business Judgment Rule Applies to Allegations of Board’s Incompetence

On August 22, 2018, the New Jersey Appellate Division issued a decision in Alloco v. Ocean Beach and Bay Club, Docket No. A-0922-16T3, holding that the business judgment rule protects a board from allegations of incompetence, explaining:

Plaintiffs also argue that the Board and its rules are incompetent. However, showing Board members or their rules were incompetent does not show that they were fraudulent, selfdealing, or unconscionable, as required by our Supreme Court.

Plaintiffs cite a Chancery Division decision, Papalexiou v. Tower W. Condo., 167 N.J. Super. 516 (Ch. Div. 1979), which stated that courts will not second-guess the actions of directors unless it appears that they are the result of fraud, dishonesty or incompetence. However, the chancery court preceded this statement by properly stating that the business judgment rule

requires the presence of fraud or lack of good faith in the conduct of a corporation’s internal affairs before the decisions of a board of directors can be questioned. If the corporate directors’ conduct is authorized, a showing must be made of fraud, self-dealing or unconscionable conduct to justify judicial review. All that is required is that persons in such positions act reasonably and in good faith in carrying out their duties.

Thus, it appears the chancery court was attempting to state the business judgment rule, not change it to an incompetence standard.

Moreover, the chancery court mistakenly cited Sarner’s language addressing, not the business judgment rule, but the requirements for imposition of a receiver: Short of a showing of such fraud, dishonesty or incompetency as would disqualify an officer or director from serving a corporation, the court will not interpose a receiver between the stockholders and the directorate to conduct the ordinary business affairs of the corporation. Even if incompetence is relevant to appointing a receiver, it does not constitute fraud, self-dealing, or unconscionability.

We have cited that language from Papalexiou and Sarner only in cases where we did not apply the business judgment rule, and thus those citations were dicta. Our Supreme Court has cited Papalexiou only as stating that fraud, self-dealing or unconscionable conduct at the very least should be subject to exposure and relief. We must continue to follow the Supreme Court’s lead and require a showing of fraud, self-dealing or unconscionable conduct.

(Internal quotations and citations omitted).

This decision touches on an area of business litigation that is a significant part of our practice: disputes regarding the management, ownership and control of closely-held businesses. Contact Schlam Stone & Dolan partner John Lundin at jlundin@schlamstone.com if you or a client have questions regarding such a dispute.

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