Ignorance Is No Excuse: To Seek Protection under California’s Business Judgment Rule, a Director Must Take Steps to Become Informed of the Authority for Her Actions

Standard

In Palm Springs Villas II Homeowners Ass’n v. Parth, 248 Cal.App.4th 268 (2016), the California Court of Appeal reinforced that the business judgment rule does not protect corporate directors against claims of breach of fiduciary duty absent proof that they exercised reasonable diligence in carrying out their corporate functions.  Before taking actions or making decisions on behalf of the corporation, corporate directors must (1) obtain a clear understanding on what authority they have and whether there are conditions to exercising that authority, (2) take the necessary steps based upon the corporation’s governing documents to exercise the authority delegated to directors, and (3) make sure they are acting in good faith and without conflicts between their interests and those of the corporation.

In Palm Springs Villas, Parth, the president and a member of the Board of Directors of the homeowners association (“HOA”), a California non-profit corporation, had taken several actions on her own without notifying the Board, including retaining a roofing company, borrowing funds secured by HOA property, and entering into long-term contracts with vendors and service providers.

When the HOA sued Parth for, among other things, breach of fiduciary duty, she sought refuge in the business judgment rule, asserting in a motion for summary judgment that application of the rule entitled her to judgment on that claim.  The trial court agreed with Parth and granted her judgment.

The appellate court reversed because evidence presented in opposition to the motion supported the claim that Parth had abdicated her duties as a director and officer; she had no idea what authority she had to take the actions she took that led to the HOA’s claims.  She had, among other things, retained a roofing company without consulting the Board or the roofing consultant retained by the HOA; acknowledged that she “did not investigate anything;” committed the HOA to loans secured by HOA assets without obtaining required authorization from the Board and without having reviewed the HOA CC&Rs or Bylaws to determine her authority to enter into those commitments; entered into a five-year landscaping contract with a vendor without any understanding or knowledge whether she had the authority to do so; and entered into a contract with a security company without obtaining authority from the Board to do so and without disclosing to the Board, when it was considering a different company, that she had already entered into the contract with that company.

California recognizes a common law business judgment rule, as well as the statutory rule at section 7231 of the Corporations Code applicable to non-profit corporations.  (See Corp. Code § 309(a) (same provision covering for-profit corporate directors).)

Under the common law, California courts defer to the business judgment of corporate directors in exercising their broad discretion to make corporate decisions; it immunizes a director from liability for a mistake in business judgment made in good faith and in the belief that it is in the best interests of the corporation, provided no conflict of interest is involved.  (Id. at 279 (citing Gaillard v. Natomas Co. (1989) 208 Cal.App.3d 1250, 1263).)  Section 7231 of the Corporations Code immunizes from liability a non-profit corporation director who performs his or her duties in accordance with the statutory standard – “in good faith, in a manner such director believes to be in the best interests of the corporation and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances.”

The business judgment rule does not help a director who has failed to act with reasonable diligence.  It does not conflict with the concept of negligence.  A court’s deference to the exercise of a director’s business judgment “presuppose[s] that judgment – reasonable diligence – has in fact been exercised.”  (Id. at 280 (citing Burt v. Irvine Co. (1965) 237 Cal. App.3d 828, 8252-53; Gaillard, 208 Cal.App.3d at 1263-64).)  Therefore, a court must find that a director exercised reasonable diligence before applying the business judgment rule.  (Id.)

A case on which Parth principally relied, Biren v. Equality Emergency Medical Group, Inc. (2002) 102 Cal.App.4th 125, did not support immunity via the business judgment rule, as a matter of law.  Biren held 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 the requisite shareholder approval.”  (Parth, 248 Cal.App.4th at 282.)  But where, as in Parth, there were triable issues of fact regarding whether the Biren exception was applicable, because of the evidence that Parth’s actions had failed to comply with the other elements of the business judgment rule, the case had to go to the fact-finder.  (Id. at 283.)

The trial court had erred in concluding as a matter of law that the business judgment rule immunized Parth from liability because he had acted “on an informed basis, [was] reasonably diligent, and exercise[d] care.”  (Id. at 283.)  There was evidence to suggest strongly that Parth failed to act with appropriate diligence and also that she acted “with willful ignorance” of whether she had authority for her actions.  (Id. at 285.)  As the Court explained: “Permitting directors to remain ignorant and to rely on their uninformed beliefs to obtain summary judgment would gut the reasonable diligence element of the rule and, quite possibly, incentivize directors to remain ignorant.”  (Id. at 286.)  Parth’s good faith also was not established as a matter of law.  (Id. at 286-87.)

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