California Court Restrains Business Judgment Rule
Court of Appeal Holds that the Business Judgment Rule does Not Protect the Actions of Businesses’ Members Who Also Sit on the Board of Directors
In Palm Springs Villas II Homeowners Association, Inc. v. Parth, the California Court of Appeal held that the business judgment rule does not shield an organization’s members for actions that harm the organization simply because they sit on the board of directors. Specifically, the Court of Appeal held that the President of the subject Association could not claim the protection of the business judgment rule simply because she was sitting on the Board of Directors.
Defendant and Cross-Complainant Palm Springs Villas II Homeowners Association (hereinafter, the “Association”) was composed of the homeowners living within the bounds of the Association and governed by a Board of Directors (hereinafter, the “Board”). The Association was governed by CC&Rs and Bylaws that provided limitations on the power of the Board to act on behalf of the Association.
Cross-Defendant Erna Parth (hereinafter “Parth”) was the President of the Association and a member of the Board. During the time period in question Parth took a number of actions on behalf of the Association in her role as a member of the Board, including hiring an unlicensed roofing contractor (without investigating the company or requesting a bid) that substantially overcharged the Association; signed promissory notes secured by the Association’s assets and property in violation of the Association’s Bylaws without reviewing the Bylaws; executed a five-year contract with a landscaper in violation of the Association’s Bylaws; and terminated a property management contract despite a prior vote of the Board to table the discussion for a later decision. Parth also signed a contract with a security company in her role as President of the Association without previously submitting the contract to the Board despite the fact that the Board had approved a resolution to obtain bids from security companies to provide security services.
Although each of Parth’s actions gave rise to the Association’s cross-complaint against Parth, it was her execution of the security contract that gave rise to the underlying lawsuit. When the Board learned of the security contract, they refused ratify it. The security company sued the Association and the Association cross-complained against Parth, asserting causes of action for breach of fiduciary duty and breach of the CC&Rs and Bylaws. Parth successfully demurred to the second cause of action and the cause of action for breach of fiduciary duty proceeded through litigation.
After substantial discovery, Parth filed a motion for summary judgment, contending that the Association’s claim for breach of fiduciary duty was barred by the business judgment rule. The lower court explained that the business judgment generally protects directors for errors in judgment as long as the directors were: “(1) disinterested and independent; (2) acting in good faith; and (3) reasonably diligent in informing themselves of the facts.” Based on the general law governing the application of the business judgment rule, and a review of the facts, the lower court granted Parth’s motion, holding that Parth had set forth sufficient evidence that she was “disinterested” and that she had “acted in good faith and without willful or intentional misconduct,” and “upon the basis of such information as she possessed.”
The Court of Appeal, however, reversed the decision of the lower court, holding that the business judgment rule did not shelter a director from liability where the director failed to act as an ordinarily prudent person and/or make a reasonable inquiry as indicated by the circumstances. The Court reviewed each of Parth’s actions as member of the Board and determined that she failed to act with reasonable diligence by failing to: investigate the companies she contracted with, determine whether she had authority to take the actions at issue, ascertain the Association’s requirements for executing promissory notes, and exercise reasonable diligence in ascertaining the extent of her authority as a Board member and President of the Association.
The Court of Appeal’s decision is significant in that it reversed the lower court’s decision and clarified the application of the business judgment rule in light of the principles of negligence and reasonable diligence. But more significantly, the Court analyzed application of the business judgment rule in relation to Parth’s actions as the President of the Association. Although Parth executed the security agreement as the President of the Association, she attempted to utilize the business judgment rule to avoid liability. The Court stated that Parth’s actions showed that she failed to make an effort to ascertain what authority she possessed to conduct the business as the President of the Association, stating that the business judgment rule “would not extend to such willful ignorance.”
This last aspect of the ruling is particularly important for businesses faced with members who have authority to act as members of the company and also as members of the board of directors. This dual role potentially raises questions concerning the applicability of the business judgment rule to the actions of its members while they are acting in their capacity solely as members. The Court of Appeal’s decision resoundingly answers this question and clarifies that the business judgment rule does not protect the willfully ignorant actions of members who are also members of the board of directors.