It is a basic tenant of corporate law that directors of a corporation are not liable for business decisions as long as the directors acted with a reasonable level of care in making these decisions. This is referred to as “the business judgment rule.” Because directors are not guarantors of corporate success, the business judgment rule specifies that a court will not review the business decisions of directors who performed their duties (1) in good faith; (2) with the care that an ordinarily prudent person in a like position would exercise under similar circumstances; and (3) in a manner the directors reasonably believe to be in the best interests of the corporation. As part of their duty of care, directors have a duty not to waste corporate assets by overpaying for property (e.g., 100% of the stock of a target company in an acquisition) or employment services. The business judgment rule is very difficult to overcome and courts will not disregard it absent, among other things, a showing of fraud or misappropriation of corporate funds.

One of the landmark cases in this area of law was Smith v. Van Gorkam, which was decided by the Delaware Supreme Court in 1985. In that case, the board of directors of TransUnion approved a merger with Marmon Group without consulting outside experts as to the fairness of the price to be paid to TransUnion shareholders, rather, the board relied on the recommendations company’s CEO and CFO, neither of whom made any substantive attempt to determine the actual value of TransUnion. Additionally, the board did not inquire as to the process used by the CEO and CFO in determining the merger consideration. As a result, the Delaware Supreme Court found that the directors of TransUnion were grossly negligent in carrying out their fiduciary duties to the company. Because of this, the board was found not to have satisfied their duty of care and were therefore not entitled to the presumptions and protections of the business judgment rule. Ultimately, the TransUnion board agreed to pay $23.5 million in damages resulting from their fiduciary duty breaches.

The facts of Facebook’s recently announced acquisition of Instagram (as reported by the Wall Street Journal) are strikingly similar to the Van Gorkam case. Allegedly, Facebook’s CEO Mark Zuckerberg and Instagram’s CEO Kevin Systrom worked out the details of the acquisition privately over the course of 3 days at Mr. Zuckerberg’s home. Once the details were finalized for the $1 billion acquisition, the deal was presented, without notice, to the Facebook board of directors who approved the deal, likely without outside expert advice as to the fairness of the transaction. According to several reports, the board vote was largely symbolic because Zuckerberg has control of 57% of the voting power of the company. Facebook directors were likely put in a precarious situation because they could face removal by Zuckerberg for not voting in favor of the acquisition, but on the other hand, they could not likely have conducted an adequate investigation of the proposed transaction to satisfy their duty of care because of the short timeframe in which the events unfolded and the lack of notice and involvement afforded to the Facebook directors.

As a result, it is possible that current Facebook shareholders could have credible grounds for a breach of fiduciary duty lawsuit if the $1 billion purchase price paid was too much. Facebook’s certificate of incorporation does provide some protection to the directors by limiting their personal liability to the company for breaches of fiduciary duty to the fullest extent permitted under the laws of Delaware (the state in which Facebook is incorporated). Delaware companies may limit director liability in this manner due to a statute which was enacted in the wake of the Van Gorkam decision.

Nonetheless, plaintiffs’ attorneys may see this as an opportunity to obtain a favorable settlement for current Facebook shareholders if the facts reported by the media are accurate. Companies and their boards of directors should be mindful of the potential issues and liabilities in any type of merger, acquisition, or similar transaction and should seek out advice from experts and legal counsel early in the process to avoid problems later on. Specifically, and as a result of the Van Gorkam decision, fairness opinions from investment bankers are considered to be almost a legal requirement in order for directors to satisfy their fiduciary duties related to any sort of significant merger or acquisition transaction.