The business judgment rule creates a presumption that directors' decisions are based on sound business judgment. This presumption can be rebutted only by a factual showing of fraud, bad faith or gross overreaching. (Ritter & Ritter v. The Churchill Condo. Assn. (2008) 166 Cal.App.4th 103, 123.) Corporate directors are presumed to have acted in good faith, on an informed basis, and in the honest belief that the action taken was in the best interest of the corporation. (Katz v. Chevron Corp. (1994) 22 Cal.App.4th 1352, 1366.)
I. Corporations Code. Even though officers and directors are deemed fiduciaries, boards are not required to make the "right" decision. Rather, they must make what they believe to be the best decision for the corporation with the available information. Corporations Code §7231(a) protects directors from personal liability if they make decisions that result in damage or loss to others, provided their decisions were made:
- In good faith (The business judgment rule immunizes directors from good faith mistakes in judgment. Barnes v. State Farm Mut. Auto. Ins. Co., (1993) 16 Cal.App.4th 365, 378); To rebut good faith, plaintiff must point to specific evidence establishing a director's conscious doing of a wrong because of a dishonest purpose or moral obliquity, furtive design or ill will. Pugh v. See's Candies, Inc. (1988) 203 Cal.App.3d 743, 763-764.)
- In a manner which the directors believe 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. (Before making decisions, boards may rely on the advice of persons they believe to be reliable and competent in the matters being presented. (Corp. Code §7231(b); also see "Competent Advice" under Due Diligence.) The phrase "in a like position" means the court will look at industry standards for volunteer homeowner association directors rather than paid professional directors. Professional directors are held to a higher standard. (See Parth Statement of Decision in the remanded case.)
Conscious Decision. For the business judgment rule to apply, boards must actually make a decision. Inaction is not protected. (In re Walt Disney Co. Derivative Litig (Del Ch 2005) 907 A.2d 693.) Weighing the facts and making a conscious decision to take no action is protected. A decision to refrain from action is different from inaction. An association is not shielded from liability if directors ignore problems. (Affan v. Portofino Cove.) However, boards can weigh the gravity of a rules violation and the likely outcome of litigation and make a good faith determination not to litigate a particular violation and their decision is protected. (Beehan v. Lido Isle.)
II. Davis-Stirling Act. As provided for in Civil Code §5800(a), a volunteer officer or director who owns no more than two separate residential interests (Civ. Code §5800(e)) 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 tortious 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 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.
III. Case Law. California Business Judgment Rule ("BJR"):
Generally, courts will uphold decisions made by the governing board of an owners association so long as they represent good faith efforts to further the purposes of the common interest development, are consistent with the development's governing documents, and comply with public policy. Thus, subordination of individual property rights to the collective judgment of the owners association together with restrictions on the use of real property comprise the chief attributes of owning property in a common interest development.… Inherent in the condominium concept is the principle that to promote the health, happiness, and peace of mind of the majority of the unit owners since they are living in such close proximity and using facilities in common, each unit owner must give up a certain degree of freedom of choice which he [or she] might otherwise enjoy in separate, privately owned property. (Nahrstedt v. Lakeside Village.)
California also has a statutory business judgment rule. Corporation Code Section 7231, subdivision (a) provides, in relevant part, " [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 . . . as an ordinarily, prudent person in a like position would use under similar circumstances." Subdivision (b) provides that the director is entitled to rely on information, opinions, and reports presented by certain specified persons. Finally, subdivision (c) provides, in relevant part, "[a] person who performs the duties of a director in accordance with subdivisions (a) and (b) shall have no liability based upon any alleged failure to discharge the person's obligations as a director . . . ." (Italics added.) The rule provides further: "no cause of action for damages shall arise against, any volunteer director . . . based upon any alleged failure to discharge the person's duties as a director" of a nonprofit organization if that person: (1) performs the duties of office in good faith; (2) performs the duties of office in a manner believed to be in the best interests of the corporation; and (3) performs the duties of office with such care, including reasonable inquiry, as an ordinary prudent person in a like position would use under similar circumstances." (Corp. Code § 7231.5, subd. (a).) The business judgment rule "sets up a presumption that directors' decisions are based on sound business judgment. This presumption can be rebutted only by a factual showing of fraud, bad faith or gross overreaching." The business judgment rules does not create a presumption which applies when a court is evaluating the independence of the committee or whether the committee acted in good faith in the first instance. (internal cites removed; Ritter & Ritter v. Churchill.)
[I]n Lamden, ample evidence demonstrated the association board engaged in the sort of reasoned decisionmaking that merits judicial deference... [p]roof . . . that the investigation has been so restricted in scope, so shallow in execution, or otherwise so pro forma or halfhearted as to constitute a pretext or sham, consistent with the principles underlying the application of the business judgment doctrine, would raise questions of good faith or conceivably fraud which would never be shielded by that doctrine.'”].) (Palm Springs Villas II v. Parth.)
[N]either a court nor minority shareholders can substitute their business judgment for that of a corporation where its board of directors has acted in good faith and with a view to the best interests of the corporation and all its shareholders. The power to manage the affairs of a corporation is vested in the board of directors. Where a board of directors, in refusing to commence an action to redress an alleged wrong against a corporation, acts in good faith within the scope of its discretionary power and reasonably believes its refusal to commence the action is good business judgment in the best interest of the corporation, a stockholder is not authorized to interfere with such discretion by commencing the action. Every presumption is in favor of the good faith of the directors. Interference with such discretion is not warranted in doubtful cases. (Beehan v. Lido Isle; internal cites and quotation marks deleted.)
A mistake of judgment on the part of a board of directors does not justify taking the control of corporate affairs from the board of directors and placing it with the stockholders. The board of directors may make incorrect decisions, as well as correct ones, so long as it is faithful to the corporation and uses its best business judgment. (Beehan v. Lido Isle.)
[T]he business judgment rule may protect a director who acts in a mistaken but good faith belief on behalf of the corporation without obtaining required shareholder approval." ... "[T]he [business judgment] rule . . . protect[s] well-meaning directors who are misinformed, misguided, and honestly mistaken." (Biren v. Equality Emergency Medical Group, Inc. (2002) 102 Cal.App.4th 125, 131-132, 137.)
Related Doctrine: Judicial Deference. There is a related rule called the "Business Judgment Doctrine" or "Judicial Deference" where courts defer to business decisions of a board even if a reasonable person could have acted differently. Absent an abuse of discretion by directors, courts will respect a board's decision.
Recommendation. Boards should adopt an Ethics Policy for directors to follow.
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