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.