By: Nathan P. Bettenhausen, Esq., Fiore Racobs & Powers, A PLC, Orange County Office
Historically, the business judgment rule “set[]up a presumption that directors’ decisions are made in good faith and are based upon sound and informed business judgment.” Lee v. Interinsurance Exchange (1996) 50 Cal.App.4th 694, 715. Under this rule, a director is not liable for mistaken corporate action that is made in good faith, in what the director believes to be in the best interest of the corporation, and where no conflict of interest exists. See Gaillard v. Natomas Co. (1989) 208 Cal.App.3d 1250, 1263. However, the recent decision in Palm Springs Villas II Homeowners Association, Inc. v. Parth (2016) 248 Cal.App.4th 268 serves as a warning that the rule may only shield directors who first demonstrate that they meet a standard of reasonable diligence. Such an approach will likely have unintended consequences, the principal ones being that the business judgment rule may be unavailable for negligent directors and it may now be entirely ineffective at the summary judgment stage.
The Parth Case:
In Parth, the Board of Directors for the Palm Springs Villas II Homeowners Association, Inc. (“Association”) derived its authority from the Association’s governing documents, which included the Declaration of Covenants, Conditions and Restrictions (“CC&Rs”) and the Bylaws. Although the governing documents empowered the Board to enter into contracts and to borrow money, they expressly limited the Board’s ability to enter into contracts longer than one year in duration without the approval of a majority of the condominium owners. Notably, the CC&Rs also contained an exculpatory provision that protected Directors from personal liability so long as their corporate conduct was made in good faith and without willful or intentional misconduct.
After the condominium owners voted against the Board’s request to levy a special assessment to offset costs connected with needed roof repairs, Parth, as President of the Board, pressed forward on her own to hire a roofing company. A contractor referred her to a roofer, but Parth neglected to investigate whether the company was licensed, failed to obtain a bid from the roofer, and was confused as to which company was ultimately hired. Nonetheless, the Board ultimately approved the retention of the roofing company. However, the Association’s expert opined that the roofer’s invoices were atypical and inflated, and that the work performed was deficient and required significant repairs.
To further complicate matters, Parth unknowingly exceeded her authority by hiring a new management company without Board approval, signing a promissory note without the approval of the condominium owners, signing a contract with a security company without Board approval, and entering into a five-year contract with a landscape company without the approval of the condominium owners. In her defense, Parth claimed that she didn’t understand the authority she was granted under the governing documents, but sincerely believed in her authority and in her need to act.
When the Board refused to ratify the security company contract, the company sued for breach of contract and the Association cross-complained against Parth alleging breach of fiduciary duty and breach of the governing documents. In her summary judgment motion, Parth successfully argued that the breach of fiduciary duty claim was barred by the business judgment rule and the exculpatory provision in the CC&Rs. The trial court found that Parth was disinterested, and acted, upon information she possessed, in good faith and without willful or intentional misconduct. As for the existence of bad faith, the trial court found that there was a triable issue as to whether Parth violated the governing documents, but concluded that such a violation was insufficient to overcome the business judgment rule or the exculpatory provision.
On appeal, the Parth court reversed and held that there were material issues of fact as to whether Parth acted on an informed basis and with reasonable diligence, thereby precluding the protection of the business judgment rule on a summary judgment motion. In so doing, the Court of Appeal explained that “whether a director exercised reasonable diligence is one of the ‘factual prerequisites’ to application of the business judgment rule.” Id. at 280. By characterizing “reasonable diligence” as a prerequisite to the rule, the Parth court suggests that the business judgment rule will only apply if directors can first demonstrate that they did not engage in negligent conduct. This would effectively remove a host of protections for directors who are merely misinformed, misguided, and honestly mistaken. See Biren v. Equality Emergency Medical Group, Inc. (2002) 102 Cal.App.4th 125, 137. Similarly, it may now become virtually impossible to successfully invoke the rule at the summary judgment stage since any conduct suggestive of negligence would raise a material issue of fact.
While the business judgment rule previously protected directors from liability for corporate actions that were unknowingly outside the scope of their authority, this ruling suggests that such a violation of the governing documents will, at least on summary judgment, bar the protection of the rule. As for the availability of the rule at trial, the Parth court leaves that very much in doubt. Parth, supra, at 284. At the very least, directors will now need to demonstrate that they attempted to ascertain the scope of their authority before conducting corporate business.
Best Practices for Directors:
To avoid personal liability and to come under the protection of the business judgment rule, prudent directors should follow best practices even during emergency situations. In situations when it’s impractical to follow corporate formalities strictly, a director should immediately thereafter apprise the board of recent developments and the basis for the director’s actions, and seek retroactive approval from the board for the actions taken.
In order to demonstrate that reasonable diligence was exercised, board meeting minutes should also carefully reflect the rationale behind corporate decisions and should document the decision-making process. Since directors will be required to affirmatively prove, in a lawsuit, that they employed reasonable diligence before taking corporate action, board meeting minutes are a valuable opportunity for them to create a written record. See, e.g., Corporations Code Section 314 (corporate minutes are prima facie evidence of the matters stated therein). And while the Parth court may have abrogated some of the protections afforded by the business judgment rule, it also reaffirmed the important role expert consultants and legal counsel play in the corporate decision-making process. See Corporations Code Section 309(b)(2) (directors are entitled to rely on the information, reports, and opinions provided by counsel and experts.) But as a cautionary tale, Parth should give pause to rogue directors: the business judgment rule isn’t what it used to be.
Nathan P. Bettenhausen is a Senior Associate Attorney at Fiore, Racobs & Powers, A PLC, where he practices business and real estate litigation, and provides representation to common interest developments. He can be reached at nbettenhausen@fiorelaw.com.
Orange County Lawyer, Volume 59, December 2016, Pg. 50
“The views expressed herein are those of the Author. They do not necessarily represent the views of the Orange County Lawyer magazine, the Orange County Bar Association, The Orange County Bar Association Charitable Fund, or their staffs, contributors, or advertisers. All legal and other issues must be independently researched.”
