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May 8, 2012

Does the Business Judgment Rule Protect the Officers of a Corporation from Personal Liability?


When corporations falter or fail, lawsuits get filed. With increasing frequency, opportunistic plaintiffs are targeting the individuals who serve on the board of directors and the officers of the corporation. The ultimate goal of the plaintiff is to find an insurance policy or high networth individuals with deep pockets. In California, when an officer or director is sued, Labor Code §2802 and/or Corporations Code §317(d) may require the corporation to defend and indemnify the individual. Regardless of whether the corporation is viable or there are insurance policies in play, the ultimate question becomes: What did the officer and director do (or fail to do) and what is the liability standard to which that individual should be held? In many instances in California, the Business Judgment Rule protects directors and requires plaintiffs to prove gross negligence against them. However, the standard is less clear with respect to officers.

In a corporation, the board of directors is responsible for hiring and firing key officers, such as the CEO, setting the policy of the corporation and making its best effort to ensure that the corporation is run in a legal and successful manner. The individuals who serve on the board (directors) are often members of the community who are not employed by the corporation; these individuals are outside directors. Other members of the board of directors may be stockholders or employees of the corporation; these individuals are considered inside directors. Since many directors come from different walks of life and bring a variety of experiences to the corporation, they are afforded more protection against lawsuits based on the premise that corporations benefit from the wide array of experience and business connections which these individuals bring to the corporate boardroom.

The protection directors receive is set forth in the Business Judgment Rule which provides that for a director to be personally liable, he or she must have engaged in grossly negligent conduct rather than simple negligence. In California, this duty of care is set forth in California Corporations Code §309, which provides that a director who performs his/her duties in accordance with this standard shall have no liability based upon any alleged failure to discharge the director’s obligations. In order to be afforded the protection of the Business Judgment Rule, a director must: (1) act in good faith, (2) be uninterested in the subject matter of the judgment, (3) be appropriately informed as to the subject matter involved, and (4) rationally believe that the judgment is in the best interest of the company. In other words, a director must take reasonable steps to keep informed and then act in the corporation’s best interest rather than his/her own interest.

Although directors and officers are frequently lumped together, there are important differences between the two. Directors are responsible for the overall success of the corporation but generally only meet every few weeks or months. By contrast, officers are high level employees who are fully compensated and probably work full-time for the corporation. Examples of officers include the chief executive officer and/or president, as well as the chief financial offi cer, chief operating officer, chief information officer, etc. These are the key individuals in a corporation who are ultimately responsible for most, if not every, facet of the corporation.

In California, the Business Judgment Rule protects directors but may not protect officers from negligence liability. California Corporations Code §309 on its face, does not apply to officers. The statute specifically refers to “directors” and makes no mention of officers. Moreover, the legislative committee comments on §309 state that “the standard of care does not include officers . . .”. California courts also hold that the Business Judgment Rule does not apply when directors are acting as officers because §309 does not relate to officers of the corporation. Galliard v. Natomas (1989) 208 Cal.App.3d 1250.

In FDIC v. Scott Van Dellen, et al., Case No. 2-10-cv-0495-DSF, the court ruled that plaintiff could not meet its burden that, as a matter of law, the California Business Judgment Rule does not apply to corporate officers because the common law component of the rule may apply even if §309 of Corporations Code does not. The Van Dellen decision was based, in part, on the conclusion that California cases may recognize a common law component of the Business Judgment Rule which does not definitively rule out application to corporate officers.

In contrast, a different judge of the U.S. District Court in FDIC as Receiver for Indymac Bank, F.S.B. v. Matthew Perry, Case No. CV-11- 5561-ODW, ruled that the defendant did not meet his burden that the Business Judgment Rule applies to corporate officers because that court found no California rule addressing the common law component of the Business Judgment Rule as to officers and placed emphasis on §309 as the codification of California’s common law Business Judgment Rule. However, the court did certify the issue for appeal.

So does the Business Judgment Rule protect corporate officers in California? Although it would seem that this is a relatively straight forward question deserving of a straight forward answer, that is not the case. The statute seems to say one thing, a California Court of Appeal case affirmed the statute’s plain language, and yet a federal court judge recently ruled that it is unclear and yet another federal court judge suggested that the 9th Circuit examine the issue. Part of the confusion in reading the pertinent cases is the lack of precision in their analysis. For example, frequently in these cases, the defendant offi cers also serve as directors. When individuals wear two different hats, the analysis may turn on whether they are acting in their capacity as an officer or as a director and the analysis can become quite complicated. During board deliberations concerning a certain course of action, the CEO, who serves on the board, may provide the background information, analysis and a recommendation, each of which prove to be faulty. In this situation, although the individual has the protection of the Business Judgment Rule while acting in his or her capacity as a member of the board of directors, the individual may have stepped outside that role and into the role as CEO, where it is less clear what the liability standard is. What makes this even more murky is that the factual analysis and the applicable cases frequently fail to precisely delineate between officers and directors and the standard for officers is unclear. Until the courts clarify these issues, it remains uncertain whether the Business Judgment Rule protects corporate officers, and if so, under what circumstances.

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