Business Judgement Rules

Corporations Code. The Corporations Code provides that even though officers and directors are fiduciaries if they make poor or incorrect decisions that result in damage or loss, they may still avoid personal liability if they performed their duties:
In good faith,
• In a manner which the 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. (Corp. Code §7231(c).)
• Given that the directors cannot ensure corporate success, the business judgment rule specifies that the court will not review the business decisions of directors who performed their duties with strict adherence to the aforementioned requirements.
• As part of their duty of care, directors have a duty not to waste corporate (Association) assets by overpaying for services or by undertaking unnecessary projects. The business judgment rule is very difficult to overcome, and courts will not interfere with directors unless it is clear that they are guilty of fraud, intentional misconduct, gross negligence, or misappropriation of corporate funds.

Davis-Stirling Act. As provided for in Civil Code §5800, a volunteer officer or director is not personally liable in excess of the association’s insurance for bodily injury, emotional distress, wrongful death, or property damage or loss as a result of the tortuous act or omission of the officer or director if all of the following criteria are met:
The act or omission was performed within the scope of the officer’s or director’s association duties.
• The act or omission was performed in good faith.
• The act or omission was not willful, wanton, or grossly negligent.
• The Association is exclusively residential.
• The director has no developer or lender affiliation.
• The director is either a tenant or owner of not more than two units or lots.
• The director serves without compensation.
• The association maintained and had in effect at the time the act or omission occurred and at the time a claim is made one or more policies of insurance which shall include coverage for (A) general liability of the association and (B) individual liability of officers and directors of the association for negligent acts or omissions in that capacity; provided, that both types of coverage are in the following minimum amount:
• At least $500,000 if the association consists of 100 or fewer separate interests;
At least $1,000,000 if the association consists of more than 100 separate interests.

Judicial Deference

• Using the Business Judgment Rule, courts will defer to board decisions even if a reasonable person would have acted differently, provided the board acted:
• In good faith,
• In the best interests of the association, and
• Upon reasonable investigation.

Limitations on Judicial Deference

It is a rule of deference to the reasoned decision-making of homeowner’s association boards concerning ordinary maintenance. It does not create a blanket immunity for all the decisions and actions of a homeowner’s association. The Supreme Court’s precise articulation of the rule makes clear that the rule of deference applies only when a homeowner sues an association over a maintenance decision that meets the enumerated criteria. Judicial deference rule will not insulate boards’ decisions from judicial review.
• Judicial deference rule does not apply where board decision is inconsistent with CC&Rs and is thus beyond board’s authority.
• The rule of judicial deference set forth in court cases provide protection from personal liability for the individual directors of a non-profit homeowner’s association. It does not follow and is not true that the same rule of judicial deference will also automatically provide cover to the entity itself. There is a difference between the standard of care, which is a reflection of the duty expected of decision makers, and the judicial deference rule, which is a modified standard of review for determining whether the actual decision-makers will be held liable for their poor decisions.

Limitation Summary

Judicial deference is limited by the following:
Where a board makes decisions contrary to the governing documents;
• Where the board fails to enforce the governing documents;
• Where responsibility for repairs is unclear;
• Where a board fails to investigate and repair.
• To challenge the actions of a corporation’s (Association) board of directors, a plaintiff assumes the burden of providing evidence that directors, in reaching their challenged decision, breached any one of the triads of their fiduciary duty — good faith, loyalty, or due care.
• Failing to do so, a plaintiff is not entitled to any remedy unless the transaction constitutes waste; that is, the exchange was so one-sided that no business person of ordinary sound judgment could conclude that the corporation has received adequate consideration.
• In effect, the business judgment rule creates a strong presumption in favor of the Board of Directors of a corporation (Association), freeing its members from possible liability for decisions that result in harm to the corporation.
• The presumption is that in making business decisions not involving direct self-interest or self-dealing, corporate directors act on an informed basis, in good faith, and in the honest belief that their actions are in the corporation’s best interest. In short, it exists so that a Board will not suffer legal action simply from making a bad decision.
• A court will not substitute its own notions of what is or is not sound business judgment if the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company.

Standard of review

The following test was constructed in as a guideline for the satisfaction of the business judgment rule. Directors in an Association should:
Act in good faith;
• Act in the best interests of the corporation;
• Act on an informed basis;
• Not be wasteful;
• Not involve self-interest (duty of loyalty concept plays a role here).

Duty of care and duty of loyalty

Although a distinct from the duty of care, the duty of loyalty is often evaluated by courts in certain cases dealing with violations by the board, which involve self-interest violations (as opposed to gross incompetence with the duty of care). Violations of the duty of care are reviewed under a gross negligence standard, as opposed to simple negligence.
• Prohibition against self-interest transactions.
• Self or conflicting interest transactions occur when a director, who has a conflicting interest with respect to a transaction, knows that he or a related person is (1) a party to the transaction; (2) has a beneficial financial interest in, or closely linked to, the transaction that the interest would reasonably be expected to influence the director’s judgment if she were to vote on the transaction; or (3) is a director, general partner, agent, or employee of another entity with whom the corporation is transacting business and the transaction is of such importance to the corporation that it would in the normal course of business be brought before the board.

Rationale

The business judgment rule is the offspring of the fundamental principle that the business and affairs of a corporation (Association) are managed by or under its board of directors. In carrying out their managerial roles, directors are charged with an unyielding fiduciary duty to the Association and its owners. The rationale for the rule is the recognition by courts that board of directors need to be free to make decisions without a constant fear of lawsuits affecting their judgment.
• The presumption raised by the Business Judgment Rule may be rebutted by the plaintiff. The business judgment rule is a presumption that in making a business decision, the directors of a corporation or an unincorporated Association acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company. Thus, the party attacking a board decision as uninformed must rebut the presumption that its business judgment was an informed one. Further, rebuttal typically requires a showing that the defendants violated the duty of care or loyalty (with courts assuming director’s good faith otherwise).