The Business Judgment Rule in California

By Styskal, Wiese & Melchione

In recent months, we have written and updated an Emerging Issues article on this subject, literally watching the law develop before our eyes. This article updates our previous observations in this ever- changing area of the law.

What is the Business Judgment Rule and Why is it So Important?

As a general proposition, directors and senior management officers (“officers”) of a financial institution (FI) owe fiduciary duties to the FI (a duty of loyalty and a duty of care). The Business Judgment Rule (BJR) precludes courts from “second guessing” decisions by (at least) directors where it is clear that the directors were not self dealing and the decision was made in good faith. In essence, the BJR establishes a presumption of decisional legitimacy that shields directors from judicial scrutiny of the results of their decisions, unless there are indications of fraud, bad faith or gross dereliction of responsibility. In short, absent clear indications that directors did something really stupid or in their own self interest in the process of making a decision, that decision cannot be challenged in court even if the result of the decision turns out to be spectacularly bad.

The BJR often functions as a “front end” legal protection and is routinely used by defense lawyers to attempt to get a dismissal of director defendants at an early stage of a lawsuit. The question in California has been, does this powerful “front end” BJR protection extend beyond directors, to officers? We have emerging clarity on this issue in California.

California Corporations Code 309(c) and Common Law

This code section is the “codification” of the BJR in California. Under this statute, the BJR protection clearly extends to directors, but is silent as to officers; however, the legislative committee notes attached to the statute suggest that it does NOT extend to officers. Given the silence of the statute, an open question has been whether there is a common law/judge created BJR which extends to officers. A seminal California state court appellate decision in 1989 (Gaillard v. Natomas) found that persons acting as “officer employees” are not protected by the BJR thus essentially ruling that (unlike most other states) there is no common law BJR in California. The Gaillard case has not been extensively followed in other states, and there was some question as to whether it or different (and favorable) case decisions would be followed in California. The latest economic downturn provided the circumstances to find out. One expected fallout from bank and credit union failures is, of course, lawsuits. Recent cases involving failed FIs have now further clarified the application of the BJR in California.

The NCUA / Wescorp Ruling

As you are probably well aware, the NCUA filed suit against select former directors and officers of Wescorp, alleging that they all violated their fiduciary duties relative to investments and that certain officers violated their fiduciary duties relative to their retirement plans. Amongst many other issues litigated in this case, the court had to deal with the application of the BJR to both directors and officers. Applying California law, the court ruled that the BJR protects directors (the court granted the directors’ motion to dismiss in August 2011, based entirely upon the BJR) but does not apply to officers. The court relied largely upon a reading of Section 309(c) and the Gaillard case.

The Indymac I / Van Dellen Rulings

The FDIC sued several former officers from the “Homebuilder Division” of Indymac Bank, claiming that they violated their fiduciary duties to the bank. In the same federal courthouse less than two months after the Wescorp ruling, a different federal judge looking at the same statute and case law, ruled that as a matter of law, the FDIC had not established that there was no common law BJR in California. Then, in October 2012, the very same judge ruled against the officers, finding that the state’s BJR does not protect officers. Confused yet? Well, there’s more.

The Indymac II / Perry Ruling

In this case, the FDIC sued the former CEO of Indymac, alleging that he violated his fiduciary duties to the bank. In the same federal courthouse just 3 months after the initial Indymac I ruling, the issue came up again. This time, the federal judge ruled that the BJR does not extend to officers.

So Where Does All This Leave Us?

It appears for now that officers have no BJR protection in California.

This has resulted, so far, in at least one large judgment against former bank officers – the officers in the IndyMac I/Van Dellen suit noted above had a $168 million judgment rendered against them in December 2012. The IndyMac II/Perry case was settled out of court in December 2012, reportedly for payment of $1 million from Perry and an assignment of insurance company rights of $1 million.

For those who study the implications of these legal developments, we believe it will have a marked effect upon how knowledgeable officers conduct themselves and how that impacts the businesses they manage. First, officers may be less inclined to take even calculated risks. Boards can encourage innovation and calculated risks by “making” the strategic decisions themselves, thus covering more decisions with the BJR at the Board level.

Second, officers who are conscientiously performing their duties will require and should be given the peace of mind of knowing that your FI has bought comprehensive insurance coverage. You should also consider extending a written indemnity agreement to the officer (backed by the FI’s reserves) to the extent insurance is not enough.

Third, while the lack of BJR protection for officers eliminates a powerful “front end” protection, an officer found to have violated his or her fiduciary duties (and liable for damages) may still seek “back end” protections through Cal. Labor Code 2802, which requires an employer to indemnify an employee for losses incurred “in direct consequence of the discharge of his or her duties …” (that appears to be “duties” in the general sense, not “fiduciary duties”).

We Can Help

Looking for ways to provide meaningful protections to your officers and structure corporate governance practices to guard against the legal challenges? Contact the seasoned professionals at SW&M for help.

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