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Feldsott Lee Pagano & Canfield
Orange County Homeowners Association Law Firm

The California Business Judgment Rule - Bruised and Confused

By Stanley Feldsott
Feldsott Lee Pagano & Canfield

Ever since the California Supreme Court published its opinion in Lamden v. La Jolla Shores Clubdominium Homeowners Assn. (1999) 21 C4th 249, 87 CR2d 237, 980 P2d 940, we have seen a proliferation of defendant directors asserting as an absolute defense the business judgment rule. Although for a while it appeared as if all activities of a Board of Directors would be protected under the umbrella of the business judgment rule, much of this came to an end with the decision of the court in Ritter & Ritter v. The Churchill Condominium Association (2008) 166 CA4th 103, where the justices correctly pointed out that Lamden by its very language only dealt with the business judgment rule in the context of ordinary maintenance decisions. It did not, for example, address activities that resulted in threats to safety, personal injury or many of the other activities that directors and associations find themselves engaged.

Recently, the California Court of Appeal for the Fourth District, Division One, in the case of Palm Springs Villas II Homeowners Association etc. et al. v. Parth (2016) 248 CA4th 268, set forth a useful discussion of the application of the business judgment rule, taking the reader from the common law rule to California's statutory provisions dealing with the business judgment rule.

Initially, the court pointed out that at common law, the "business judgment rule" was really a judicial policy of giving deference to corporate directors in the exercise of their discretion in making corporate decisions. Under this rule, a director was not liable for a mistake in business judgment which is made in good faith and in what he or she believes to be the best interests of the corporation and where no conflict of interest exists.

In California, the Corporation Code codifies the business judgment rule, making it applicable to nonprofit corporations. Corporation Code §7231 states that:

  • "(a) A director shall perform the duties of a director . . . 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 statute goes on to state that:

  • "(c) A person who performs the duties of a director in accordance with [the preceding subdivisions] . . . shall have no liability based upon any alleged failure to discharge the person's obligations as a director . . ."

Section 7231.5 sets forth limited liability on the same grounds for volunteer directors and officers.

It should be kept in mind that the business judgment rule, when applicable, protects directors but not the Association itself. For example, in the Ritter & Ritter case, supra, all of the directors were sued, along with the Association. Although the jury found that none of the directors had been negligent, the Association was nevertheless held liable. As pointed out by the Court, ibid, deference to a director's business judgment does not always immunize the director from liability in the case of his or her abdication of corporate responsibilities. Additionally, the Court notes there is no conflict between the business judgment rule on the one hand and the concept of negligence on the other. A finding of protection under the business judgment rule presupposes that reasonable diligence has, in fact, been exercised. A director cannot close his or her eyes to what is going on in the conduct of the business of the corporation and have it said that he or she is exercising business judgment. Likewise, a director who fails to attend a board meeting may incur, if facts warrant, for any liability that might flow from decisions made at that meeting by the directors present.

Whether a director has exercised reasonable diligence is a factual prerequisite to application of the business judgment rule. The burden of proof is on the director/board to establish the factual prerequisite for applying the rule of judicial deference at trial. Where, for example, there was no evidence that the board engaged in 'reasonable investigation' before choosing to continue its 'piecemeal' approach to sewage backups, judicial deference will not apply. The codification of the business judgment rule is for the most part set forth in Corporations Code §7231(a) which mandates that a director perform the duties of a director, including duties as a member of any committee of the board upon which the director may serve in:

  1. good faith;
  2. a manner such director believes to be in the best interests of the association; and
  3. with such care, including reasonable inquiry, as an ordinary prudent person in a like position would use under similar circumstances.

The Code goes on to provide that a director shall be entitled to rely upon information, opinions, reports or statements, including financial statements and other financial data, in each case prepared or presented by (a) one or more officers or employees of the association whom the director believes to be reliable and competent in the matters presented, and (b) counsel, independent accountants or other persons as to matters which the director believes to be in within such person's professional or expert competence.

So, for example, if you are dealing with a property management issue, reliance upon the advice of your property manager would afford the director protection. Obtaining what is tantamount to a legal opinion from the property manager would not bring the director within the ambit of Corporations Code §7231. There is no liability of a director for the acts of a committee on which the director does not serve, where the committee members are protected, or in a situation where they are protected by the business judgment rule, so long as:

  1. the committee is acting within its designated authority;
  2. the director believes their actions merit confidence;
  3. provided the director acts in good faith after reasonable inquiry when need therefor is indicated by the circumstances; and
  4. does not have knowledge that would cause such reliance to be unwarranted.

The application of the business judgment rule to a large extent involves many factual determinations: Did the director really believe he was acting in the best interests of the association? Was the reliance reasonable? Was it a matter that does entitle the director to judicial deference? These are all determinations that are made after the fact. Having appropriate insurance with reasonable policy limits cannot be over-emphasized. A full and complete discussion with your broker as to the types of policies you should have and the policy limits is a director's first line of defense.

An insurance company's duty to defend in California is broader than its duty to indemnify. In most cases, when a claim is made the insurance company will provide a defense (and often payment to settle) with what is called the reservation of rights letter, in which the carrier in essence is saying some or all of these claims are not or may not be covered by your policy, but we will nevertheless provide a defense. The costs of increasing policy limits frequently makes good sense.

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