Corporate Governance: Director's Duty - Good Faith, Reasonable Care, and Business Judgment, Summaries of Business

Download Corporate Governance: Director's Duty - Good Faith, Reasonable Care, and Business Judgment and more Summaries Business in PDF only on Docsity! Study B-601 STATE OF CALIFORNIA CALIFORNIA LAW REVISION COMMISSION BACKGROUND STUDY Whether the Business-Judgment Rule Should Be Codified Professor Melvin A. Eisenberg School of Law University of California, Berkeley May 1995 This background study was prepared for the California Law Revision Commission by Professor Melvin A. Eisenberg. No part of this background study may be published without prior written consent of the Commission. The Law Revision Commission assumes no responsibility for any statement made in this background study, and no statement in this background study is to be attributed to the Commission. The Commission’s action will be reflected in its own recommendation which will be separate and distinct from this background study. The Commission should not be considered as having made a recommendation on a particular subject until the final recommendation of the Commission on that subject has been submitted to the Legislature. Copies of this background study are provided to interested persons solely for the purpose of giving the Law Revision Commission the benefit of their views, and the background study should not be used for any other purpose at this time. California Law Revision Commission 4000 Middlefield Road, Room D-1 Palo Alto, CA 94303-4739 C ONT E NT S I. Introduction: Standards of Conduct and Standards of Review in Corporate Law ................................................. 1 II. Functions and Duties of Directors and Officers ....................... 1 III. The Business-Judgment Rule .................................. 4 IV. California Case Law ........................................ 8 V. Cal. Corp. Code § 309........................................ 9 VI. Conclusion and Recommendation .............................. 10 – 5 – prudent person would reasonably be expected to exercise in a like position and under similar circumstances.… 1 Cal. Corp. Code § 309(a) reflects both general law and California case law. I will call the standard of conduct in Cal. Corp. Code §309(a), RMBCA § 8.30(a) and Principles of Corporate Governance §4.01(a) “the standard of careful conduct.” This standard has both objective and subjective elements. The portions of the standard that requires the care that “an ordinarily prudent person in a like position would use under similar circumstances” is an objective standard. The portions of the standard that require “good faith,” and actions that the director “believes to be in the best interests of the corporation and its shareholders,” are subjective standards, although, as will be discussed below, they may have at least a minimal objective component as well. The application of the standard of careful conduct to the functions of directors results in several distinct duties: (i) Directors must reasonably monitor or oversee the conduct of the corporation’s business to evaluate whether the business is being properly managed, by regularly evaluating the corporation’s principal senior executives and ensuring that appropriate information systems are in place. This is known as the duty to monitor. (ii) Directors must follow up reasonably on information acquired through monitoring systems, or otherwise, that should raise cause for concern. This is known as the duty of inquiry. (iii) Directors must make reasonable decisions on matters that the board is obliged or chooses to act upon. (iv) Finally, directors must employ a reasonable decision-making process to make decisions. Officers have comparable duties, although for most officers decision-making is likely to be more important than monitoring. On its face, the standard of careful conduct is fairly demanding. This is particularly true of the element of prudence or reasonability. For example, in San Leandro Canning Co., Inc. v. Perillo, 84 Cal. App. 627, 633, 258 P. 666, 669 1. Section 4.01(a) reads in full: (a) A director or officer has a duty to the corporation to perform the director’s or officer’s functions in good faith, in a manner that he or she reasonably believes to be in the best interests of the corporation, and with the care that an ordinarily prudent person would reasonably be expected to exercise in a like position and under similar circumstances. This Subsection (a) is subject to the provisions of Subsection (c) (the business judgment rule) where applicable. (1) The duty in Subsection (a) includes the obligation to make, or cause to be made, an inquiry when, but only when, the circumstances would alert a reasonable director or officer to the need therefor. The extent of such inquiry shall be such as the director or officer reasonably believes to be necessary. (2) In performing any of his or her functions (including oversight functions), a director or officer is entitled to rely on materials and persons in accordance with §§ 4.02 and 4.03 (reliance on directors, officers, employees, experts, other persons, and committees of the board). – 6 – (1927), the court said that: “[The directors] were bound to exercise that degree of care which men of common prudence take in their own concerns ….” (Emphasis added.) In Burt v. Irvine Co. 237 Cal. App. 2d 828, 852, 47 Cal. Rptr. 392, 407-08 (1965), the court said that: “‘The rule exempting officers of corporations from liability for mere mistakes and errors of judgment does not apply where the loss is the result of failure to exercise proper care, skill and diligence. “Directors are not merely bound to be honest; they must also be diligent and careful in performing the duties they have undertaken. They cannot excuse imprudence on the ground of their ignorance or inexperience, or the honesty of their intentions; and, if they commit an error of judgment through mere recklessness, or want of ordinary prudence and skill, the corporation may hold them responsible for the consequences.”’” (Emphasis added.) III. The Business-Judgment Rule Despite the apparently demanding quality of the standard of careful conduct, in practice the standard of review of disinterested conduct by directors or officers is often significantly less stringent, especially when the substance or quality of a decision — that is, the reasonableness of the decision, as opposed to the reasonableness of the decision-making process that has been used — is called into question. In such cases, a much less demanding standard of review may apply, under the business-judgment rule. The business-judgment rule consists of four conditions and a special standard of review that is applicable, if the four conditions are satisfied, in suits that are based on the substance or quality of a decision a director or officer has made. The four conditions are as follows: First, a judgment must have been made. So, for example, a director’s failure to make due inquiry, or any other simple failure to take action, does not qualify for protection of the rule. (However, a deliberately made decision to not take a certain action would normally satisfy this condition.) Second, the director or officer must have informed himself with respect to the decision to the extent he reasonably believes appropriate under the circumstances — that is, he must have employed a reasonable decision-making process. Third, the decision must have been made in subjective good faith — a condition that is not satisfied if, among other things, the director or officer knew that the decision violates the law. Fourth, the director or officer may not have a financial interest in the subject matter of the decision. For example, the business-judgment rule is inapplicable to a director’s decision to approve the corporation’s purchase of his own property. If these four conditions are met, then the substance or quality of the director’s or officer’s decision will be reviewed, not under the standard of careful conduct to determine whether the decision was prudent or reasonable, but only under a much – 7 – more limited standard. There is some difference of opinion as to how that limited standard should be formulated. A few courts have stated that the standard is whether the director or officer acted in good faith. It is often unclear, however, whether good faith, as used in this context, is purely subjective or also has an objective element. One of the few places where a definition of good faith is codified is the Uniform Commercial Code, but even the Code lacks clarity on this point. The Code’s General Provisions (Part I) provide that good faith means “honesty in fact in the conduct or transaction concerned.”2 Although that definition seems to be subjective, it may not be. A person may be deemed to act honestly if he acts according to his own best lights, or a person may be deemed to act honestly only if he acts according to his own best lights and without transgressing the basic moral standards set by society. Furthermore, under the Code’s Sales provisions (Part II) a merchant’s duty of good faith includes an explicitly objective element — “the observance of reasonable commercial standards of fair dealing in the trade.”3 Similarly, Judge Friendly held, in another context, that “Absent some basis in reason, action could hardly be in good faith even apart from ulterior motive.”4 Correspondingly, most courts have not limited the standard of review under the business-judgment rule to subjective good faith, but instead have employed a standard that involves some objective review of the quality of the decision, however limited. As William Quillen, formerly a leading Delaware judge, has stated: “[T]here can be no question that for years the courts have in fact reviewed directors’ business decisions to some extent from a quality of judgment point of view. Businessmen do not like it, but courts do it and are likely to continue to do it because directors are fiduciaries.”5 Even courts that seem to use the term “good faith” in a relatively subjective way nevertheless almost always review the quality of decisions, under the guise of a rule that the irrationality of a decision shows bad faith.6 Courts have adopted an objective standard in applying the business-judgment rule because a purely subjective good faith standard would depart too far from the general principles of law that apply to actors who have a duty of care, and serious problems would arise if even an irrational business decision was protected solely because it was made in subjective good faith. Accordingly, the prevalent formulation of the standard of review, under the business-judgment rule, is that if the four conditions to that rule have been 2. U.C.C. § 1-201(19). 3. U.C.C. § 2-103(1)(b). 4. Sam Wong & Son, Inc. v. New York Mercantile Exchange, 735 F.2d 653, 678 n.32 (2d Cir. 1994). 5. William T. Quillen, Trans Union, Business Judgment, and Neutral Principles, 10 Del. J. Corp. L. 465, 492 (1985). 6. See In re RJR Nabisco, Inc. Shareholders Litig., [1988-89 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 94,194, 91,715 (Del. Ch. Jan. 31, 1989). – 10 – incentive effect of discouraging bold but desirable decisions. Putting this more generally, under a standard of review based on reasonability or prudence, directors might tend to be unduly risk-averse because if a desirable although highly risky decision had a positive outcome the corporation but not the directors would gain, while if it had a negative outcome the directors might be required to make up the corporate loss. The business-judgment rule helps to offset that tendency. IV. California Case Law Undoubtedly as a result of the considerations discussed in Section III, the business-judgment rule is part of the common law of corporations, and various formulations of the rule have been accepted by the California courts. However, these formulations often lack clarity. Some cases have articulated a reasonability standard. For example, in Fornaseri v. Cosmosart Realty & Building Corp., 96 Cal. App. 549, 557, 274 P. 597, 600 (1929), the court said: “In the absence of fraud, breach of trust or transactions which are ultra vires, the conduct of directors in the management of the affairs of a corporation is not subject to attack by minority stockholders in a suit at equity, where such acts are discretionary and are performed in good faith, reasonably believing them to be for the best interest of the corporation.” (Emphasis added.) In Burt v. Irvine Co. 237 Cal. App. 2d 828, 852, 47 Cal. Rptr. 392, 407-08 (1965), the court said that: “‘The rule exempting officers of corporations from liability for mere mistakes and errors of judgment does not apply where the loss is the result of failure to exercise proper care, skill and diligence. “Directors are not merely bound to be honest; they must also be diligent and careful in performing the duties they have undertaken. They cannot excuse imprudence on the ground of their ignorance of inexperience, or the honesty of their intentions; and, if they commit an error of judgment through mere recklessness, or want of ordinary prudence and skill, the corporation may hold them responsible for the consequences.”’ … ‘Courts have properly decided to give directors a wide latitude in the management of the affairs of a corporation provided always that judgment, and that means an honest, unbiased judgment, is reasonably exercised by them.… ’” (Emphasis added.) In Findley v. Garret, 109 Cal. App. 2d 166, 174 (1952), the court said that “Where a board of directors … acts in good faith within the scope of its discretionary power and reasonably believes … [its] action is good business judgment in the best interest of the corporation, a stockholder is not authorized to interfere with such discretion.… ” Other cases have articulated a good-faith standard. For example, in Marble v. Latchford Glass Co., 205 Cal. App. 2d 171, 178, 22 Cal. Rptr. 789 (1962) the court said that it would “not substitute its judgment for a judgment of the board of directors made ‘in good faith.’” Similarly, in Eldridge v. Tymshare, Inc., 186 Cal. App. 3d 767, 776, 230 Cal. Rptr. 815 (1986) the court stated that the business judgment rule “sets up a presumption that directors’ decisions are based on sound business judgment [and] … this presumption can be rebutted only by a factual – 11 – showing of fraud, bad faith or gross overreaching.” Still other cases seem to treat good-faith and reasonability standards as if they were interchangeable. For example, in Gaillard v. Natomas Co., 208 Cal. App. 3d 1250, 1263, 256 Cal. Rptr. 702 (1989), the court said: The common law “business-judgment rule” refers to a judicial policy of deference to the business judgment of corporate directors in exercising their broad discretion in making decisions.… Under [the business judgment] rule, a director is 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 corporation, where no conflict of interest exists.… “ … Courts have properly decided to give directors a wide latitude in the management of the affairs of a corporation provided always that judgment, and that means an honest, unbiased judgment, is reasonably exercised by them.… ’”10 V. Cal. Corp. Code § 309 In Gaillard v. Natomas Co., supra, the court stated that Cal. Corp. Code §309 “codifies California’s business-judgment rule.” 208 Cal. App. 3d at 1264. See also Barnes v. State Farm Mutual Auto Insurance Company, 16 Cal. App. 4th 365, 379 n.12, 20 Cal. Rptr. 2d 87 (1993). This is incorrect. Section 309 codifies the standard of careful conduct, with which the business-judgment rule is inconsistent. Indeed, an argument could be made that Section 309 overturns the business- judgment rule, because the business-judgment rule is established by case law, while the standard of Section 309, which is inconsistent with the business- judgment rule, is statutory. The better position, however, is that although Section 309 does not codify the business-judgment rule, neither does it overturn the rule. Thus Harold Marsh, who was chair of the State Bar Committee that authored Section 309(a), states: This subdivision is largely copied from a proposed revision of former Section 35 of the Model Business Corporation Act adopted by the Committee on Corporate Laws of the American Bar Association …. It can be seen at a glance that it incorporates the two seemingly contradictory ideas which have been voiced by the courts, i.e., the idea of good faith and acting “in a manner such director believes to be in the best interests of the corporation”, … and the idea of reasonable care, expressed as “such care as an ordinarily prudent person in a like position would use under similar circumstances” …. While these are not expressed as alternatives or as being applicable in different situations, but as cumulative requirements of the director, the ABA committee which drafted this language apparently considered that it was not 10. In Katz v. Chevron Corp., 22 Cal. App. 4th 1352 (1994), the court stated that “‘A hallmark of the business judgment rule is that a court will not substitute its judgment for that of the board if the latter’s decision can be attributed to any rational business purpose,.’” Id. at 1366 (citation omitted, quoting from Unocal v. Mesa Petroleum, 493 A.2d 946, 954 (Del. 1984) (emphasis added) and that “‘director liability is predicated upon concepts of gross negligence.’” (quoting Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984). This case involved Chevron, a Delaware corporation, and was presumably decided under Delaware law. – 12 – overruling the business judgment rule by this formulation. The Report of the ABA Committee on Corporate Laws with respect to this revised Section 35 of the Model Act stated that it intended by this language to incorporate “the familiar concept that, these criteria being satisfied, a director should not be liable for an honest mistake of business judgment.” While it could be argued that the qualifying phrase, “these criteria being satisfied,” means that the director must always satisfy the standard of reasonable care imposed and therefore is always liable for negligence, that would make this comment nonsensical. A director then would be liable for an honest mistake of business judgment, if it was made negligently. Since this distinguished committee of corporate lawyers presumably meant to say something by this comment, it can only be interpreted as an indication that they, at least, intended to preserve the business judgment rule. In the light of this background, it is highly doubtful that the California courts will hold that this section was intended to abolish the business-judgment rule, although it would certainly be open to a court to interpret it in that fashion, if it simply focused on the literal words of the statute. 1 H. Marsh & R. Finkle, Marsh’s California Corporation Law § 11.3 (3d ed. 1990). VI. Conclusion and Recommendation Given the justifications and importance of the business judgment rule, and the uncertainty of its status and formulation in California, it would be desirable to codify the rule legislatively. The simplest approach would be to amend Cal. Corp. Code § 309 by incorporating the formulation of the business-judgment rule in American Law Institute’s Principles of Corporate Governance § 4.01(c). Revised § 309 would read as follows: (a) A director shall perform the duties of a director, including duties as a member of any committee of the board upon which the director may serve, in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances. (b) A director or officer who makes a business judgment in good faith fulfills the duty under this Section if the director or officer: (1) is not interested in the subject of the business judgment; (2) is informed with respect to the subject of the business judgment to the extent the director or officer reasonably believes to be appropriate under the circumstances; and (3) rationally believes that the business judgment is in the best interests of the corporation. (b) (c) In performing the duties of a director, a director shall be entitled to rely on information, opinions, reports or statements, including financial statements and other financial data, in each case prepared or presented by any of the following: (1) One or more officers or employees of the corporation whom the director believes to be reliable and competent in the matters presented.