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THE BUSINESS JUDGMENT RULE FOR CORPORATE DIRECTOR
FIDUCIARIES
Introduction:
A fiduciary to a
business owes a high duty of care to the business as discussed in our
articles on
fiduciary duties,
corporate opportunity
doctrine and
limited liability entities. Self
dealing and putting one’s own self interest above that of the company
can lead to personal liability and gross negligence can lead to legal
action for breach of the duty of due care.
A different but
related question arises as to whether the corporate fiduciary is liable
for honest errors in business judgment that lead to loss to the company.
Over the years, the Courts have examined this question and have
developed the BUSINESS JUDGMENT RULE which delineates the liability that
corporate officers, directors, and, to a lesser extent, partners and
general partners may owe to the owners of the company for errors in
judgment.
This article shall
outline the Business Judgment Rule.
Basics:
The Business
Judgment Rule (hereafter ”BJR”) provides that mere errors in judgment in
and of themselves may not create liability on the part of the fiduciary
to the company but only if the fiduciary is a director. The law is less
generous as to its role with other fiduciaries, such as officers,
general partners or managing members of an LLC.
Courts are divided
on the application of the BJR to non-corporate entities. Although one
Court has clearly stated that the BJR does not apply to
non-corporate entities, other Courts have applied the common law BJR to
limited partnerships.
The general duty
imposed upon a director in California is codified.
Cal. Corp. Code §
309(a) states:
A director shall
perform the duties of a director, including duties as a member of any
committee of the board upon which the director may serve, in good faith,
in a manner such director believes to be in the best interests of the
corporation and its shareholders and with such care, including
reasonable inquiry, as an ordinarily prudent person in a like position
would use under similar circumstances.
However, the Courts
have delineated the interpretation on that statutory duty to limit its
broad sweep. The BJR has been stated as having two components:
one which
immunizes [corporate] directors from personal liability if they act in
accordance with its requirements, and another which insulates from court
intervention those management decisions which are made by directors in
good faith in what the directors believe is the organization's best
interest.
Lee v.
Interinsurance Exchange
(1996) 50 Cal. App. 4th 694, 714.
Assuming the board
acted in good faith in what it thought was the best interest of the
company, utilizing criteria in making the decision that a reasonably
prudent person would use, then the Court will normally not “second
guess” the directors even if they were wrong and even if the Court would
have disagreed with their action.
Neither Statutory
Nor Common Law BJR Applicable to Corporate Officers.
Courts have held
that the BJR specifically applies only to corporate directors, not
corporate officers because corporate officers are not performing the
duties of directors. Gaillard v. Natomas Co. (Cal. App. 1st
Dist. 1989) 208 Cal. App. 3d 1250, 1265-1266. In Gaillard, the
Court determined that inside directors were not, as a matter of law,
protected by the statutory BJR. Id. The decision in Gaillard
made clear that not only was the BJR only available to corporate
directors, but where directors were also officers, their decisions would
not be protected by the BJR. Id.
The Court in
Lamden v. La Jolla Shores Clubdominium Homeowners Ass'n (1999)
stated: "[t]raditionally, our courts have applied the common law
'business judgment rule' to shield from scrutiny qualifying decisions
made by a corporation's board of directors." 21 Cal. 4th 249, 259
(citing Marsili v. Pacific Gas & Elec. Co. (1975) 51 Cal. App. 3d
313, 324; Fairchild v. Bank of America (1961) 192 Cal. App. 2d
252, 256-257; Findley v. Garrett (1952) 109 Cal. App. 2d 166,
174-175; Duffey v. Superior Court (1992) 3 Cal. App. 4th 425, 429
(rule applied to decision by board of incorporated community
association); Beehan v. Lido Isle Community Assn. (1977) 70 Cal.
App. 3d 858, 865 (same)).
This means that the
Court could impose an objective test as to whether the officers were
acting in a reasonably appropriate manner in making the decision protect
the corporate interest…the Court can second guess them.
Refusing BJR
Protections to Board of Unincorporated Association.
One Court has spoken
clearly on the issue of the BJR and non-corporate entities: "neither the
California statute nor the common law business judgment rule, strictly
speaking, protects noncorporate entities." Lamden v. La Jolla Shores
Clubdominium Homeowners Ass'n (1999) 21 Cal. 4th 249, 259.
In Lamden,
the Court was asked to apply the BJR to the decisions of the board for
an unincorporated homeowner's association. Although ultimately
deferring to the board, the Court refused to apply the BJR to the
board's decision because it was not a corporate entity. Instead, the
Court applied a test of objective reasonableness to the board's
statutory discretionary decision-making authority.
The Lamden
Court concluded that § 309(a) applied specifically, and only, to
corporate directors by its plain language. Id. ("California's
statutory business judgment rule contains no express language extending
its protection to noncorporate entities or actors"). The Court used the
plain language interpretation of the term "directors" to conclude that
the statutory BJR was only available to corporate entities.
Despite the Court's
conclusion in Lamden that "neither the California statute nor the
common law business judgment rule, strictly speaking, protects
noncorporate entities," California Courts have applied the common law
BJR to certain limited partnerships. See Lee, 50 Cal. App. 4th
at 712. In applying the BJR to limited partnerships, Courts have relied
on Wyler v. Feuer (1978) 85 Cal. App. 3d 392, 402 to draw an
analogy between limited partnerships and corporate business judgment:
These
characteristics–limited investor liability, delegation of authority to
management, and fiduciary duty owed by management to investors–are
similar to those existing in corporate investment, where it has long
been the rule that directors are not liable to stockholders for mistakes
made in the exercise of honest business judgment, or for losses incurred
in the good faith performance of their duties when they have used such
care as an ordinarily prudent person would use. By this standard, a
general partner may not be held liable for mistakes made or losses
incurred in the good faith exercise of reasonable business judgment.
[Internal citations omitted]
The Wyler
case, as well as subsequent cases relying on Wyler, involved
corporate entities who had organized into partnerships, either limited
partnerships or general partnerships.
The reasoning of
Wyler presents a significant challenge: "The good faith business
judgment and management of a general partner need only satisfy the
standard of care demanded of an ordinarily prudent person, and will not
be scrutinized by the courts with the cold clarity of hindsight." 85
Cal. App. 3d at 403. This "ordinarily prudent person" standard of care
is the same as that articulated in the BJR, although the Court stops
short of specifically stating that the good faith of the general partner
will be presumed, as is the case under the BJR.
BJR Does Not Protect
Against Breach of Fiduciary Duty
Regardless of
whether a general partner or managing member is a director, an officer,
or both, the BJR will not protect him or her for any breach of his
or her fiduciary duty. In the context of assessing a special litigation
committee's independence, the Court stated:
policy reasons for
keeping a court from evaluating after the fact the wisdom of a
particular business decision do not apply when the issue is whether a
party to that decision acted fraudulently or in bad faith. The
assessment of fraud or bad faith is a function courts are accustomed to
perform, and in performing it the courts do not intrude upon the process
of business decision-making beyond assuring that those decisions are not
improperly motivated.
Desaigoudar v.
Meyercord
(Cal. App. 6th Dist.
2003) 108 Cal. App. 4th 173, 188.
Practicalities:
A business person
who makes an honest mistake is going to know that the owners will
possibly fire him or her or, at the least question and limit his or her
future authority. And any business person who violates his or her duty
to the company will undoubtedly find him or herself a defendant in a
legal action for breach of fiduciary duty.
But for honest
errors made with reasonable cause to believe they may be right, the
director, at least, and perhaps other fiduciaries are probably safe from
personal liability so long as there is some reasonable rationale for the
decision, even if wrong. For directors the protection is the highest.
But given the cost
of litigation and the need to justify at least the reasonable grounds
for the decision, the wise fiduciary will make a good record of
investigating the possibilities before making a decision and reduce that
inquiry into writing so that at a later time the thought process can be
demonstrated.
But a famous judge
once told the writer that he was not in business, himself, and was not
going to sit in judgment on past decisions made if the fiduciaries
demonstrated a modicum of due care. “I’m just a guy in a black robe, “
he told me, "and my decision long after the fact is irrelevant. I
wasn’t there, didn’t feel the pressure…”
But that same judge
once found for us against a fiduciary who had pocketed a finder’s fee on
the side for his own replacement. When I mentioned his earlier comments
to me, he laughed. “Being wrong is one thing. Acting wrong is another.”
Good judge. |
