The Calif. Business Judgment Rule: Does It Apply to Corporate Officers and What Are the Insurance Implications if It Does Not?
By Stephen P. Wiman, Thomas D. Long, and David J. Farkas, Nossaman LLP
In California, recent litigation involving the Federal Deposit Insurance Corporation, as a receiver, and failed bank directors and officers has brought sharply into focus the California Business Judgment Rule (“BJR”) and its applicability to corporate officers. Thus far, the majority of courts considering the issue have ruled that the BJR, as it exists in California, does not apply to corporate officers subject to California law.1 This is significant because without the cover of the BJR, corporate officers can be liable for simple negligence, and this makes the existence of insurance all the more important.
The California Business Judgment Rule Does Not Apply to Officers
The California Legislature codified the BJR in section 309 of the Corporations Code.2 Section 309 provides in relevant part:
(a) A director shall perform the duties of a director, including duties as a member of any committee of the board upon which the director may serve, in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances.
(c) A person who performs the duties of a director in accordance with subdivision (a) and (b) shall have no liability based upon any alleged failure to discharge the person’s obligations as a director. …
On its face, the BJR applies only to corporate directors, not to officers. The Court of Appeal in Gaillard v. Natomas Company 3 confirmed this: “As stated by Marsh in his discussion of section 309: ‘[Section 309, subdivision (a)] does not relate to officers of the corporation, but only to directors … . [A]n officer-director might be liable for particular conduct because of his capacity of an officer, whereas the other directors would not.’” 4California courts otherwise have frequently referenced (sometimes in dicta) the standard of care which section 309 creates as one imposed on “directors.” 5
There are good reasons why the BJR should not apply to corporate officers. Unlike directors, officers do not need the BJR to induce service. Directors need liability protections to induce risk taking because their relatively small stockholdings and lack of incentive compensation give them little of the “upside” gains on investment projects. In contrast, officers receive higher absolute levels of pay than do directors, and a significant portion of that pay is likely based upon performance. Unlike directors, officers stand to reap substantial rewards for serving and taking risks. Additionally, officers receive significantly greater rewards from a corporation than do directors. Officers work for the company full time, possess extensive knowledge and skill concerning company affairs, and have access to considerably more and better information than directors and exercise great influence over the lives of many people. For these reasons, officers should be held to a greater standard of responsibility.
Counsel representing corporate officers often cite cases that are inapposite because they involve the directorial conduct of an individual who was both a director and an officer. In Biren v. Equality Emergency Medical Group, Inc,6 the cross-defendant Biren was both a director and officer. The Court of Appeal ruled that insofar as the cross-complaint challenged Biren’s conduct as a director, the BJR precluded liability.7 The court expressly held: “Here we conclude, among other things, that the business judgment rule may protect a director who acts in a mistaken but good faith belief on behalf of the corporation without obtaining required shareholder approval.” 8However, as to Biren’s conduct as the close corporation’s chief financial officer, she was liable for simple negligence for failing to pay pension plan contributions timely.9 In 1st Valley Credit Union v Bland, the district court rejected the argument that Biren applied the BJR to corporate officers.10
Some defense counsel also assert that a person who serves both as an officer and a director (an inside director) may use the BJR to shield his conduct as an officer. They cite the Legislative Comment to section 309 of the Corporations Code as alleged support for their position. The Comment states in part:
The standard of care [of the business judgment rule] does not include officers. The Committee on Corporate Laws [of the American Bar Association] concluded that:
“ … it was not appropriate in connection with a revision of Section 35 to deal with those officers who were not also directors of the corporation. Although a non-director officer may have a duty of care similar to that of a director as set forth in Section 35, 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 … .”
Reliance upon this comment is problematical. First, the fact that an officer is also a director should not lessen the more stringent standard of conduct demanded when the individual performs the duties of a corporate officer.
Second, the quoted ABA committee report does not state that the BJR protects an inside director for conduct as an officer. Also, the report does not specifically address section 309 and simply provides background on why officers should be subject to a stricter standard of care.
Third, this argument is directly contrary to the Corporations Code. There is nothing in section 309 of the Corporations Code which suggests that it applies to the conduct of a corporate officer acting in that role, even though the officer may also be a director.
Fourth, section 204(a)(10) of the Corporations Code permits corporations, with certain significant limitations, to include within their articles a provision eliminating a director’s personal liability for monetary damages for breaches of duties as set forth in section 309. This provision, however, expressly does not permit the corporation to limit the liability of a director for actions as an officer should the person also be a corporate officer.11 “This means ‘inside’ directors … remain exposed to liability for their conduct as officers.”12 Section 204(a)(10) undercuts any argument that section 309 insulates conduct of directors/officers as officers.
Finally, Gaillard, makes it clear that the BJR does not apply to an inside director.13 In Gaillard, the court’s holding that the BJR does not apply to officers was in the context of inside directors.14
Defense counsel also often argue that regardless of section 309′s applicability only to directors, a corporate officer may take advantage of a purported “common law” BJR. Counsel rely upon Lee v. Interinsurance Exchange 15 for this proposition. In Lee, the Court of Appeal stated the common law BJR rule has two components: “one which immunizes directors from personal liability if they act in accordance with its requirements, and another which 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 interests.” 16 According to the Lee court, “[o]nly the first component is embodied in section 309.” 17
Commentators characterize the first component of the common law BJR as a “defensive prong” and label it the business judgment “rule” which “shields a director from personal liability for participating in a decision that a reviewing court might conclude was imprudent. That is to say, the business judgment rule is used defensively.” 18 These commentators label the second component the business judgment “doctrine,” which they say operates as “in the nature of a presumption” and is used offensively.19 The “doctrine” is a principle of “judicial restraint in the face of, and giving deference to, the decision of a board of directors, in a context in which personal director liability is not involved.” 20 An example of such a decision is a board decision “on behalf of a corporation that pursuit of [a derivative] suit is not in the best interests of the corporation and that it should be abandoned.” 21
First, other than the recent aberration of Poggetto v. Switzer, the BJR has never been applied to officers in California. Lee itself involved directors. Barnes v. State Farm Mutual Auto. Ins. Co.,22 to which the Lee court referred in its discussion of the issue, involved application of the rule to directors, not officers.23
Second, it is the first component of the alleged common law BJR that would be implicated as to personal liability, not the second component. However, that first component, as the Lee court acknowledged, is embodied in section 309. Thus, “in California the component [of the common law] rule relating to directors’ personal liability is defined by statute.” 24
In Poggetto v. Switzer,25 the court held that the BJR applied to officers based upon the second prong of the “common law” BJR. However, the court simply got it wrong. Again, that prong has nothing to do with director or officer liability.
In short, there is nothing in California law that supports interposing the BJR to defeat negligence claims against corporate officers.
Ensure Adequate Insurance
Coverage for Corporate Officers
Even if the BJR were to protect officers, officers still need protection from claims against them, particularly where the corporation fails. Where the BJR does not apply and where the institution has failed, such as in the case of bank failures, the need for improved Directors’ and Officers’ (“D&O”) insurance is greater. Many directors and officers are probably not aware of all of the questions they should consider in evaluating whether D&O insurance would be adequate to protect them in a catastrophic situation. We discuss a few of the more significant issues below.26
First, are the limits adequate? For most D&O insurance, the policy limits are quickly eroded by defense costs. This is true even though D&O policies are typically not “duty to defend” policies. The insurers nonetheless have a duty to advance defense costs on the prospect that the claim may be covered and likely will have little financial recourse to turn to if the claim proves not to be covered and will therefore likely contend that the payment of defense costs reduces policy limits no matter what.
Significant corporate failures can spawn dozens of lawsuits with dozens of insured defendants each seeking their own representation. Public filings relating to the IndyMac Bank failure reveal that over $50 million in insurance was consumed in defense costs for over a dozen lawsuits, only one of which went to trial. Even if directors and officers think that they need D&O insurance only to cover the costs of attorneys’ fees, high policy limits may still be insufficient.
Policy limits should also be considered in light of the net worth of the individuals being insured. If a corporation is purchasing D&O insurance to provide not only a defense against claims but also indemnity in the event that liability is found, then the available policy limits should be more attractive to the plaintiff than the portion of the insured party’s non-exempt assets that is subject to execution on a judgment. Every plaintiff’s lawyer in evaluating his client’s claim makes a choice at the outset of the case as to whether to primarily pursue insurance coverage or personal assets of individual defendants. The better theories for establishing culpability of individual defendants and maximizing recovery may be theories of fraud or other intentional misconduct such that insurance does not apply. It is important for every defendant whose personal assets are exposed to liability to make sure that he or she has insurance that is more attractive to a potential plaintiff than his or her non-exempt assets.
Second, are the policy limits shared among parties with conflicting interests? Most corporations seem to have shared D&O insurance limits in which officers, inside directors and outside directors share and share alike. In a number of different factual scenarios, outside directors will have interests that are directly at conflict with those officers. Outside directors may want their own pot of insurance available both to defend themselves and to provide a basis to negotiate a separate settlement free from the interests of officers, who may have very differing interests from the outside directors and who may be significantly more culpable (and thus less able to negotiate an early settlement) than outside directors if there is any evidence of wrongdoing.
Third, is the D&O insurance policy rescindable? Again, outside directors need to be particularly wary. The D&O application will be filled out by officers typically with information known only to them. If there is a material misrepresentation, the policy may be subject to rescission even if the outside directors know nothing of the misrepresentation, and even if the misrepresentation was a result of carelessness rather than malevolence. A D&O policy that protects the outside directors only if the officers are doing a good job misses the point of D&O coverage for outside directors.
Fourth, are the policy limits shared with the corporation itself? It is common for D&O policies to contain coverage for the corporation’s obligations to indemnify directors and officers (“Side B coverage”) and coverage for the corporation itself against certain types of securities claims (“Side C coverage”). Coverage which protects only the directors and officers (“Side A coverage”) often shares limits with Side B and Side C coverage at least at lower levels. The greater the sharing of limits, the greater potential disadvantage to the directors and officers in terms of being able to use the insurance proceeds for their own defense and for settlement.
Fifth, what exactly is the scope of protection under the insurance policy? Although D&O policies broadly cover the insureds against liability arising out of “wrongful acts,” they are often riddled with exclusions that take away protection from the very sort of catastrophic situations where officers and directors need protection. For example, if a corporation fails, will claims by its bankruptcy trustees, its creditors committees, its receiver, etc. be treated as claims of the corporation itself such that the “insured v. insured” exclusion applies and directors and officers obtain no protection from the insurance at all?
It is beyond the scope of this article to go through all of the issues that can be created by the precise language of a D&O policy. Suffice it to say the underwriters will endeavor to learn the corporation’s business as well as they can and, where possible, craft policy exclusions designed to eliminate coverage for the very risks that are most dangerous for the corporation’s particular line of business. Directors and officers and their insurance brokers need to be attentive to the policy forms when purchasing the policies and need to review the policy forms carefully to consider how they will apply when they are most needed.
The majority of courts thus far addressing the issue have held that the California BJR does not apply to corporate officers. In order to minimize the risk of personal assets to claims of simple negligence, corporate officers should take care to assure that they are covered by substantial D&O insurance, carefully reviewed by brokers and insurance coverage counsel.
Stephen P. Wiman and Thomas D. Long are partners and David J. Farkas is an associate in Nossaman LLP‘s Litigation Department in Los Angeles, Calif. They can be reached at email@example.com, firstname.lastname@example.org, and email@example.com.
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