The business judgment rule insulates directors from liability from bad decisions if certain conditions are met. A recent U.S. District Court opinion holds that the business judgment rule does not apply to corporate officers.
Federal Deposit Insurance Corp. v. Perry
In Federal Deposit Insurance Corp. v. Perry (C.D. CA December 13, 2011) (Case No. CV 11-5561 ODW), Defendant Matthew Perry, Indymac’s chief executive officer, allegedly permitted the production of a pool of more than $10 billion in risky residential loans intended for sale into the secondary market. Due to the volatility of the secondary market, however, Indymac was forced by the fourth quarter of 2007 to transfer the loans into its own investment portfolio, which ultimately generated a loss of more than $600 million. On July 11, 2008, Indymac closed and the FDIC was appointed as its receiver. The FDIC sued Perry under 12 U.S.C. § 1821(d)(2) and 12 U.S.C. § 1821(k), alleging that, as chief executive officer, he breached his duties to Indymac and acted negligently in allowing Indymac to continue to generate and purchase loans for sale into the secondary market.[1]
Perry brought a motion under FRCP Rule 12(b)(6) to dismiss for failure to state a claim. Perry argued that the business judgment rule protected him on his decisions as an officer, but the FDIC argued that the business judgment rule applies only to directors, not officers, and though Perry was also a director, they were suing him for his actions in his capacity as an officer.
The district court denied the motion to dismiss, holding that the business judgment rule under California law does not apply to decisions of corporate officers.
Citing Berg & Berg Enterprises, LLC v. Boyle 178 Cal.App.4th 1020, 1045, the court said that the common law business judgment rule has two components, one that immunizes directors from personal liability if they act in accordance with its requirements, and another that 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. The district court said that California courts traditionally have applied the common law business judgment rule to shield from scrutiny decisions made by a corporation’s board of directors, and the district court’s research disclosed no California case law applying the common law business judgment rule to corporate officers. Indeed, it cited one case as holding that judicial deference afforded under the business judgment rule should not apply to interested directors who effectively were acting as officers.
Furthermore, California Corporations Code § 309, which codifies the common law business judgment rule, expressly applies to directors. The court said that the legislative committee’s comments show that it was the drafters’ intent not to include officers when codifying the business judgment rule. It quoted the Legislative Committee Comment as follows:
Although a non-director officer may have a duty of care similar to that of a director [ ], his ability to rely on factual information, reports or statements may, depending upon the circumstances of the particular case, be more limited than in the case of a director in view of the greater obligation he may have to be familiar with the affairs of the corporation.
In light of the apparent lack of authority and the California legislature’s express intent not to include corporate officers in Corporations Code § 309 when codifying the common law business judgment rule, the court held that the business judgment rule does not protect corporate officers’ decisions.
Comment
It should be noted that this decision is a ruling at the pleading stage, and judges can be reluctant to dismiss cases before the facts can be fleshed out.
The court is entirely correct in saying that officers are not included in the protection of Corporations Code § 309. Marsh’s California Corporation Law states that § 309(a) “does not relate to officers of the corporation, but only to directors.” Id. at § 11.03[A].
There is no doubt that the omission of officers from Corporations Code § 309 was not an oversight. According to Marsh’s California Corporation Law, § 309(a) is largely copied from a proposed revision of former section 35 of the Model Business Corporation Act adopted by the Committee on Corporate Laws of the American Bar Association (with certain modifications). The committee stated “it was not appropriate in connection with a revision of Section 35 to deal with those officers who were not also directors .…” Id. at § 11.03[A].
Marsh’s California Corporation Law points out that:
Of course, an officer does have a duty of care in connection with his position in the corporation, which is probably greater than that of a director. That was one of the reasons why it was thought inappropriate to attempt to treat the two in the same section. It was also believed that it was unnecessary to attempt to codify the duties of officers, since these would vary considerably depending upon the position which the officer held with the corporation, although the duties of directors would not seem to vary solely in their capacity as directors. Of course, an officer-director might be liable for particular conduct because of his capacity as an officer, whereas the other directors would not. Id. at § 11.03[A].
Officers are typically compensated much more highly than directors, and unlike directors, they typically devote their full working time to the corporation’s business. Therefore, it is reasonable to hold officers to a different standard than directors.
That being said, however, it is not clear that making a wrong decision, even one that looked like a bad decision at the time, is negligence on the part of an officer for which he will be held liable. Corporations Code § 309 is a codification of the common law business judgment rule, but codification does not necessarily preclude further development of the common law rule. According to Marsh’s California Corporation Law, “there is no case in the United States, with one possible exception [a Pennsylvania case], holding a director liable for a mere wrong-headed decision, even if the director was alone in his or her economic forecasts or other basis for the course of action adopted.” Id. at § 11.03[A].
The same reason for excusing “wrong-headed” decisions by directors applies to officers as well. Holding a CEO liable for a corporation’s entire loss because of a mistaken business judgment is not conducive to innovation. Thus, it is possible that officers who act in what they believe to be in the best interest of the corporation, who have no conflict of interest, and who make an informed judgment will not be deemed to have violated any duty to the corporation no matter how “wrong-headed” their judgment may have been.
In the meantime, this decision is likely to spur inclusion of exculpation clauses in executive employment agreements more frequently than in the past, and in some cases, corporate counsel might recommend bylaw clauses that expressly provide officers with protection similar to that afforded directors by the business judgment rule.
[1] Although the FDIC sued under a federal statute allowing it to sue directors and officers of a federally insured depositary institution for money damages, the U.S. Supreme Court has ruled that the standard of care is set by state law (so long as the standard is not more lax than gross negligence). Atherton v. FDIC, 519U.S. 213 (1997).
