Does the business judgment rule (BJR) protect corporate officers in California? This question is overlooked, yet is important to all executives who do business in California.
Under California law, the business judgment rule shields corporate directors from legal liability for decisions that they make in good faith and in the best interests of the corporation. California Corporations Code Section 309 codifies the protection that members of the board of directors enjoy from personal liability. While Section 309 mentions directors, it conspicuously does not mention officers. Thus, whether the BJR applies to corporate officers in California is a matter to be determined by the courts.
FDIC v. Perry: The BJR and Corporate Officers in California
In a recent case, FDIC v. Perry (Central District of California, Case No. CV 11-5561 ODW (MRWx), December 13, 2011), the court applied California law to decide whether the BJR applied to officers of the corporation. The FDIC, acting as receiver for Indymac Bank, alleged that his former CEO, Matthew Perry, negligently permitted the production of a pool of more than $10 billion in risky, residential loans intended for sale into the secondary market. Because the secondary market was highly volatile, Indymac was forced to move the loans into its own investment portfolio. The FDIC alleged that Perry, by aggressively gambling by investing in these risky loans, acted inconsistently with how a reasonable banker would have acted under similar circumstances. Because of Perry's actions, the loans that were transferred into Indymac's portfolio produced losses of more than $600 million.
Perry moved to dismiss the suit on the basis that the BJR applies to corporate officers under California law. After an exhaustive review of California cases, the court concluded that the BJR does not apply to corporate executives:
California courts traditionally have applied common law BJR to shield from scrutiny qualifying decisions made by a corporation's board of directors. See, e.g., Lamden v. La Jolla Shores Condominium Homeowners Ass'n,21 Cal.4th 249, 259 (1999) (emphasis added). Detracting from its traditional application, Defendant proposes that common law BJR apply to corporate officers as well as directors. Defendant's proposition, however, seems unprecedented as the Court's research reveals no judicial decision in California applying common law BJR to corporate officers.
(boldface added)
The court carefully differentiated between protections afforded to directors versus protections afforded to officers. In particular, where a director who is also officer is carrying her responsibilities as an officer, the BJR is of no help to the defendant:
Rather, one decision by the California Court of Appeal has held that judicial deference afforded under BJR should not apply to interested directors who effectively were acting as officers. Gaillard v. Natomas, Co., 208 Cal.App.3d 1250, 1265 (Ct. App. 1989) ("[Interested directors] were not 'perform[ing] the duties of a director' as specified in section 309, but were acting as officer employees of the corporation. The judicial deference afforded underthe businessjudgmentrule therefore should not apply.") (citation and quotations omitted). The Court of Appeal further articulated that "an offïcer-director might be liable for particular conduct because of his capacity as an officer, whereas the other directors would not. This result is in accord with the premise of the business judgment rule that courts should defer to the business judgment of disinterested directors who presumably are acting in the best interests of the corporation." Gaillard, 208 Cal. App. 3d at 1265.
After examining the legislative history, the court noted that the California legislature deliberately excluded officers from the scope of the business judgment rule. In explaining this difference, the legislature specifically mentioned "the greater obligation of officers to be familiar with the operations of the corporation."
Implications for Officers
What about Delaware? Delaware law also applies the BJR differently to directors and officers. Although both directors and officers have fiduciary duties to the corporation, Delaware statutes permit corporations to the eliminate personal liability for breach of fiduciary duties for directors, but not for officers. Moreover, no Delaware court has explicitly held that the BJR covers officers. Therefore, it is unclear whether Delaware law provides superior protection to officers.
If the BJR does not shield executives, they must take special care in making business decisions, lest they face liability for them in the future. Officers should take the following actions to minimize their risks and liabilities:
- Become familiar with their fiduciary duties. Corporate officers who do not understand their duties could underestimate their liability and lead the company to engage in needless risks. As officers become more aware of their responsibilities, they become more able to decide which risks might be interpreted after the fact as a breach of their fiduciary duties.
- Review the corporation’s D&O liability insurance to understand what situations the policy covers and what it excludes.
- If the corporation does not indemnify its officers in its articles of incorporation or corporate bylaws, then negotiate an indemnification provision that falls within the boundaries of California Corporations Code Section 317 on indemnification. This section limits indemnification against liability for breaches of fiduciary duty.
- Consider how potential personal liability affects their decisions and the relationship with the board.
CEOs, CFOs, and COOs: Did you think that the business judgement rule covers corporate officers?
Twitter: @DougYPark
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