LawFlash

California Business Judgment Rule Does Not Shield Corporate Officers From Personal Liability

January 25, 2012

Introduction

A recent California district court ruling (Federal Deposit Insurance Corporation v. Matthew Perry, C.D. Cal., No. CV 11-5561 ODW (MRWx), December 13, 2011), refused to extend the protections of the California business judgment rule defense to the alleged negligent actions of the former Chief Executive Officer of Indymac Bank. California’s “business judgment rule” (codified under Section 309(a) of the California General Corporation Law) provides that directors of California corporations, who act in good faith, in a manner believed to advance the best interests of the corporation and its shareholders, and with such care, including reasonable inquiry, as an ordinarily prudent person in such position would use under similar circumstances, are not personally liable for an alleged failure to discharge their fiduciary duties so long as they acted in accordance with such statutory standard. By adopting a strict interpretation of the statute and citing legislative history and lack of specific precedent, the court concluded that the California business judgment rule intentionally excludes corporate officers.

This decision suggests that even though officers of California corporations generally owe the same fiduciary duties of good faith, due care and loyalty to the corporation and its shareholders as directors, courts may be reluctant to expand the business judgment rule defense to corporate officers who, unlike directors, have a broader obligation due to their more in-depth knowledge of the corporation’s operations.

Factual Background and Court’s Analysis

The Federal Deposit Insurance Commission (FDIC) complaint charged Perry (in his capacity as CEO) with negligence in driving the Indymac Bank to originate more than $10 billion in high risk, residential loans slotted to be sold in the secondary market. The loans subsequently had to be absorbed into the bank’s own investment portfolio in 2007, ultimately resulting in losses in excess of $600 million. In his Motion to Dismiss, Perry argued that the California business judgment rule applies to him in his capacity as an officer and that, therefore, FDIC was required to specifically plead around this defense in the complaint allegations.

The court denied Perry’s Motion to Dismiss and held that the business judgment rule, as codified by Section 309(a), does not apply to corporate decisions of officers. The court observed that the text of Section 309(a) does not expressly reference officers and noted the absence of controlling precedent indicating that the business judgment rule protections should be extended to cover actions of officers. The court also cited specific California legislative committee comments relating to the original adoption of Section 309(a) that suggest that the drafters intentionally omitted officers from the standard of care protections set forth in the statute on grounds that directors, with limited knowledge of the daily affairs of the corporation, should be afforded the right to rely on factual reports or statements submitted by officers while officers, on the other hand, have a greater obligation to be familiar with the affairs of the corporation and, therefore, should not be entitled to the business judgment rule protections.

Discussion and Related Implications

Because officers generally owe the same or similar fiduciary duties to California corporations and their shareholders as directors, there has been an assumption in academic and legal circles that the business judgment rule protections that insulate California directors from personal liability should also apply equally to officers. The Perry decision now indicates that the assumption may have been misplaced and officers may be held to a higher standard of care in the judicial review of their erroneous business judgments.

The Perry decision could be overturned on appeal or subsequently limited to its specific facts, but as it stands, officers of California corporations, as well as officers of out-of-state corporations qualified to conduct business in California or deemed subject to California’s corporate laws by virtue of their significant operations within California (also known as quasi-California corporations),1 must be mindful of the greater potential for personal liability associated with their corporate decision-making as executives. Moreover, California directors who also hold officer positions could potentially face a higher burden of proof associated with the loss of the business judgment rule presumption in cases where skillful plaintiffs are able to style their allegations as an alleged fiduciary breach of the individual’s officer (rather than director) duties. In reaching its conclusion, the Perry court also seems to have ignored the widely accepted rationale behind the business judgment rule, namely, to encourage executive management to take reasonable and informed risks in business decisions.

Both, Delaware and California corporate statutes distinguish between directors and officers for purposes of eliminating personal liability of the corporate actor for certain fiduciary duty breaches. For example, both California and Delaware corporate statutes allow corporations to include exculpatory provisions in their charters to insulate directors, but not officers, from personal liability for monetary damages from breaches of their fiduciary duties so long as the acts or omissions of the directors do not fall within one of the statutorily enumerated situations where such liability cannot be eliminated.2 California’s statute further expressly provides that no such exculpatory provision can eliminate the liability of an officer for an act or omission as an officer, even if that officer is also a director or his negligent actions were ratified by the directors.3 However, despite these statutory similarities, the Perry decision seems to depart from settled Delaware case law that the fiduciary duties of directors and officers are identical and, therefore, at least in Delaware, officers should be entitled to the same defenses as directors at the pleading stages in a shareholder derivative lawsuit, including the business judgment rule.4 

Though the Perry decision may potentially expose California corporate officers to increased liability for breach of fiduciary duty claims, there are other venues through which officers can be protected from personal exposure for actions taken in their executive capacity in good faith and in the best interests of the corporation. First, most corporations typically maintain directors and officers insurance policies that indemnify members of the board, management and other corporate agents against personal liability in derivative lawsuits where the corporate actor ultimately prevails on the merits.5 In addition, both California and Delaware corporate law permits corporations to indemnify directors and officers who acted in good faith and in a manner reasonably believed to be in the best interests of the corporation against judgments, costs and expenses incurred by these individuals in lawsuits alleging fiduciary duty breaches in their capacities as a corporate agent and, in fact, many corporations elect to include mandatory indemnification provisions in their corporate charters to indemnify directors and officers to the maximum extent permitted by law.3 Furthermore, executive officers will continue to be protected by the prevailing corporate practice of entering into individual indemnification agreements with directors and officers that provide these individuals a contractual right (in addition to any right to indemnification that may be included in the corporate charter) to reimbursement of damages and other litigation expenses in the event that their business acts are subsequently challenged in a shareholder lawsuit and adjudged to have been lawful.

Finally, the California Labor Code sets forth another statutory standard under which certain lower-level management employees could seek indemnification from their corporate employers in connection with acts taken in their officer capacities. Section 2802 of the California Labor Code requires an employer to indemnify an employee (which includes officers) for all necessary expenditures or losses6 incurred by the employee in direct consequence of the discharge of his or her duties or of his or her obedience to the directions of the employer. Though a Chief Executive Officer who is implementing corporate policy and making business judgments is not likely to win the argument that he or she was acting in an “obedience of the directions of the employer,” a second-tier vice-president or similar lower-level officer might successfully characterize his or her actions as within the scope of the additional indemnification protections of Section 2802.

For more information, please contact the authors of this alert:

Stephen Alexander, Partner
stephen.alexander@bingham.com, 213.680.6518


1 Section 2115 of the California General Corporation Law requires foreign corporations to comply with specified California corporate law provisions (including, among others, Section 309(a)) if certain property, payroll and sales thresholds are exceeded.

2 See Gantler v. Stephens, 965 A.2d 695 (Del.Supr. 2009). Though the court did not expressly hold that Delaware’s business judgment rule protections would apply to officers, the Gantler decision suggests that officers subject to the identical fiduciary duties would have the same defenses, including the business judgment rule.    Section 204(a)(10) of the California General Corporation Law and Section 102(b)(7) of the Delaware General Corporation Law both provide that a corporation’s charter can include a provision eliminating or limiting the personal liability of a director for monetary damages for breach of fiduciary duty, except in instances involving a breach of director’s duty of loyalty, conflicts of interest with the corporation or deriving improper personal benefits from a transaction with a corporation; intentional misconduct, knowing or reckless violations of law, or acts in bad faith; unlawful dividends or redemptions; and certain other enumerated exceptions.

3 See Section 204(a)(10)(C) of the California General Corporation Law. 

4 See Gantler v. Stephens, 965 A.2d 695 (Del.Supr. 2009).  Gantler involved a plaintiff’s appeal of the lower court’s grant of the defendants’ (both directors and officers) motion to dismiss certain breach of fiduciary duty complaint counts for failure to plead specific facts sufficient to overcome the business judgment rule (BJR) presumption.  In its reversal of the Court of Chancery, the Delaware Supreme Court applied the same analysis with respect to defendant-directors as to defendant-officers, concluding, in each case, that, with respect to both types of defendants, the plaintiffs pled sufficiently detailed facts of wrongdoing to state a claim that the directors and officers breached their respective fiduciary duties (once the court concluded that plaintiffs pled sufficient facts to overcome the BJR presumption as to directors, the court similarly analyzed whether plaintiffs pled sufficient facts to state a fiduciary duty claim as to officers).  As such, Gantler seems to stand for the proposition that both directors and officers have the benefit of BJR at the pleading stage and plaintiffs must plead specific facts around this defense.  

5 However, absent a legislative change to Section 309(a), we could see an increase in directors and officers’ insurance policy premiums for California and quasi-California corporations because of the statute’s lower ordinary negligence standard, which, in the absence of the business judgment rule protections, will make it more difficult to successfully dismiss lawsuits filed against corporate officers at the pleading stages.

6 The statute defines this term to include all reasonable costs, including, attorneys' fees incurred by the employee.  

This article was originally published by Bingham McCutchen LLP.