On September 6, 2013, a Federal Court in Texas held that the business judgment rule did not apply to a corporate decision to hire a law firm. You might be thinking, “I thought Texas was business friendly and conservative.” Are directors and officers in Texas facing newfound liability risks in the state? Probably not. In re: 320 Auto.com, LLC, 213 WL 480642 (Bkrtcy. S.D. Tex., September 6, 2013), the court held that the business judgment rule does not apply when a Chapter 7 Trustee in bankruptcy seeks to employ his own law firm to represent the estate. Obviously, the business judgment rule was never intended to protect all corporate decisions and decision makers. Where a conflict of interest is present, i.e., a bankruptcy trustee hiring his own law firm, the business judgment rule has no applicability. To the contrary, self-dealing fiduciaries are held to the highest standard, with the burden falling on the fiduciary to demonstrate the fundamental fairness of any self-dealing transaction. Int’l Bankers Life Ins. Co. v. Holloway, 368 S.W.2d 567, 577 (Tex. 1963). Accordingly, the decision in In re: 320 Auto.com, LLC is consistent with the fundamental principal that the business judgment rule generally applies to decisions made by disinterested and reasonably informed directors and officers who honestly believe their decisions are in the best interest of the company. Courts outside of Texas, however, appear to be taking a more restrictive approach to the application of the business judgment rule.
In NECA-IBEW Pension Fund Ex Rel. Cincinnati Bell, Inc. v. Cox, 2011 WL 4383368 (S.D. Ohio Sept. 20, 2011), the Plaintiff brought a shareholder’s derivative suit against directors of Cincinnati Bell after the CEO was granted a significant bonus following a year in which net income, earnings per share, share price and shareholder return declined significantly. The shareholders voted against the approval of the executive compensation decision and then brought a derivative suit against the board of directors. The directors filed a motion to dismiss under Rule 12(b)(6). The court denied the motion to dismiss, stating that the business judgment rule “imposes a burden of proof, not a burden of pleading”. Id. at *2. The court further stated that “these factual allegations raise a plausible claim that the multimillion dollar bonuses approved by the directors at a time of the company’s declining financial performance violated Cincinnati Bell’s “pay for performance” compensation policy and were not in the best interest of Cincinnati Bell shareholders and therefore constituted an abuse of discretion and/or bad faith”. Id. at *3. It must be noted that the court reached this conclusion without any facts having been pled by the Plaintiff suggesting an abuse of discretion or bad faith on the part of the directors. The decision also seems to violate a fundamental tenet of the business judgment rule that courts should not substitute their inexperienced business decisions for the good faith decisions of independent and diligent business executives.
The Cincinnati Bell decision has been roundly criticized and many courts have declined to follow its holding. See, e.g., Plumbers Local No. 137 Pension Fund v. Davis, 2012 WL 104776 (D. Or. Jan. 11, 2012); Laborers’ Local v. Intersil, 868 F. Supp. 2d 838 (N.D. Cal. 2012). In fact, the court in Plumbers Local, indicated that “it is unlikely that the case remains viable legal authority.” Plumbers Local, 2012 WL 104776 at *8. It should be further pointed out that plaintiff’s counsel in the Cincinnati Bell case was sanctioned by the court for failing to disclose negative authority related to the “say on pay” issue. Questions were also raised as to whether the court had appropriately conferred jurisdiction over the case. Id.
While the Cincinnati Bell holding has not gained traction with other courts, the business judgment rule is coming under assault with some success in various jurisdictions. In California, for example, the business judgment rule is codified in California Corporation Code at § 3.09. While the California statute specifically references corporate directors, it wholly fails to mention corporate officers. Courts in other jurisdictions have generally held that business judgment rule protection extends to corporate officers. See e.g. Kelly v. Bell, 266 A.2d 878, 879 (D. Eo. 1970); Detwiler v. Offenbecher, 728 F.2d 103, 149 (S.D.N.Y. 1989); Amerifirst Bank v. Bomar, 757 F. Supp. 1365, 1376 (S.D. Fla. 1991). However, in FDIC v. Perry, 2012 WL 589569 (C.D. Cal. Feb. 21, 2012), a U. S. District Court held that the business judgment rule does not provide protection for decisions made by officers of California corporations. The court based its decision on both California common law and the state statute. With respect to California common law, the Court found no prior decisions which applied the business judgment rule to officers. Without elaboration, the court rejected the assertion that the general principal of deference to business decisions should apply to officers.
Plaintiff’s attorneys are also finding innovative ways around the business judgment rule. A prime example of this has arisen in the litigation against British Petroleum (“BP”) as a result of the deep water horizon oil spill. Directors and officers of BP were confronted with a securities class action suit, alleging that they had misrepresented and failed to disclose information regarding BP’s safety programs and concomitant risk exposure. The directors and officers at BP attempted to argue to the court that the securities claims should be dismissed because the allegedly wrongful conduct was merely mismanagement. However, the court rejected this argument, referencing the fact that the plaintiff’s had alleged that BP launched an ongoing public relations campaign prior to the oil spill in an effort to improve BP’s safety image with investors. See In re: BP, PLC Sec. Litig., 758 F.2d Supp. 428 (S.D. Tex., 2012).
Are other inroads being made to limit the application of the business judgment rule? Are plaintiff’s attorneys using other arguments to circumvent the rule’s applicability? On Friday, December 13, 2013, Dan A. Bailey, a nationally recognized author and expert regarding D&O responsibilities and insurance, will address this as he presents an update on the business judgment rule at the DRI Professional Liability Seminar. Please join us
at the seminar for informative presentation.