California Court Clarifies “Business Judgment Rule” re Personal Liability of Directors

Unpublished California Appellate Court decision (entered April 2, 2014):

This case involved an action by an owner against the Association and individual members of the Association’s board of directors based on claims of negligence and breach of fiduciary duties. The trial court sustained demurrers of the individual defendants without leave to amend and granted a motion to strike claims for negligence and the Plaintiff appealed.

In applying the “business judgment rule,” the Court stated that there is a presumption that directors’ decisions are based on sound business judgment. To rebut the presumption, there must be a showing of fraud, bad faith or gross overreaching and the plaintiff seeking to impose liability must allege sufficient facts to establish the fraud, bad faith or gross overreaching. More is need than conclusory allegations of improper motive and conflict of interest. The court further ruled that a good faith mistake in business judgment does not breach the statutory standard. If there was a reasonable basis for the decisions, they are protected by the business judgment rule.

The court also stated that the business judgment rule has been justified primarily on two grounds: (1) that directors should be given wide latitude in their handling of corporate affairs because the hindsight of the judicial process is an imperfect device for evaluating business decisions; and (2) the business judgment rule recognizes that shareholders voluntarily undertake the risk of bad business judgment – “anyone who buys a unit in a common interest development with knowledge of its owners association’s discretionary power accepts the risk that the power may be used in a way that benefits the community but harms the individual.

In commenting on the plaintiff’s claims based on the tort of negligence, the Court stated that directors are not personally liable in tort unless their action, including any claimed reliance on expert advice, was clearly unreasonable under the circumstances known to them at that time. The defense of reasonable reliance on expert advice is necessary to avoid holding a director personally liable when he or she reasonably follow expert advice or reasonably delegates a decision to a subordinate or subcommittee in a better position to act.

See case decision: Roslyn_Lane_LLC_v._Gallagher_(Cal._App._2014)1