Attorneys who commonly litigate breach of fiduciary duty claims are often confronted with the question of whether the so-called “Business Judgment Rule” is a reliable defense. Appellate decisions addressing the intersection of these competing principles are quite scarce but the reasoning of trial courts can still be useful guides for developing strategies. Our recent trial experience on this issue sheds significant light on which approaches work (and which do not), and so we offer them along with a few observations on common threads.
The Competing Principles
- It has long been recognized that the so-called “Business Judgment Rule” in its various forms purports to insulate executives and entity managers from civil liability so long as their decisions were within the broad range of reason, even if the decisions turned out to be negligent. As one court put it, it “insulates from court intervention those management decisions which are made by directors in good faith in what the directors believe is the organization’s best interest.” Berg & Berg EnterSus, LLC v. Boyle, (2009) 178 Cal. App. 4th 1020, 1045.
- It is equally well established, however, that an entity such as a limited partnership can be forbidden to take actions which disproportionately impact minority interests. As the court in Enea v. Superior Court (2005) 132 Cal. App. 4th 1559 explained, the standard is not whether the decision is a “rational choice” because a partner cannot obtain “even the slightest advantage” over its partner.
- This rule also extends to sister or co-owned entities. “[U]nder the single-enterprise rule, liability can be found between sister companies.” Las Palmas Associates v. Las Palmas Center Associates (1991) 235 Cal.App.3d 1220, 1249. That is, the single enterprise rule recognizes that “it would be unjust to permit those who control companies to treat them as a single or unitary enterprise and then assert their corporate separateness in order to commit frauds and other misdeeds with impunity.” Id. at p. 1249.
- Further still, a person such as an officer or manager or director individually liable for conspiring (with his or her employer) to breach and/or aiding or abetting breach of its fiduciary duty. American Master Lease LLC v. Idanta Partners, Ltd. (2014) 225 Cal.App.4th 1451, 1471-1477.
- Finally, there is potential alter ego liability for fiduciary duty breaches. As one court observed, “[w]here a parent corporation (or, for that matter, anyone) that owns all of a subsidiary’s stock operates that subsidiary in a matter that renders the subsidiary merely an alter ego of its parent (and a ghost of its former, independent self), courts can pierce the so-called ‘corporate veil’ and treat the two as one.” Santa Clarita Organization for Planning & Environment v. Castiac Lake Water Agency (2016) 5 Cal.App.5th 1084, 1105.
Some Comments on Specific Examples of Rulings Where There is Conflict Between These Principles
- In one trial last year we sued the majority partner of a limited partnership which owned several scrap metal facilities located within a certain geographic region. The majority partner had purchased a nearby facility from a struggling third party owner and we claimed usurpation of a partnership opportunity. The defendant had made the acquisition in its own name, but had promptly announced that it was not going to open the store for the indefinite future, so its defense was “no harm, no foul.”
On behalf of the minority partner, we conducted discovery and found internal emails in which the majority partner had concluded that the new store had historically created a negative impact on the partnership’s market share. In other words, while the majority might not have actually made money, the new store would have been in competition if it had opened. Thus, by inference, the majority had taken an opportunity the partnership might have enjoyed, depriving it of potential income. We prevailed on the point that the business judgment rule did not protect the majority from our breach of fiduciary duty claims since the key question is always whether there was any “detriment to the partnership.” See Jones v. Wells Fargo Bank (2003) 112 Cal.App.4th 1527, 1540; Page v. Page (1961) 55 Cal.2d 192, 197.
The take-away point here seems to be that the question is not one of monetary damages, and indeed they were not awarded as to a future income stream. But the new store was an opportunity and so one could reasonably expect that a Court would order disgorgement of title to the store plus all attorney’s fees needed to obtain a disgorgement judgment. This is what we obtained.
- In a second case, we sued one of the world’ s largest banks for failing to disclose to our national pension fund client the fact that it was unloading the shares it directly held in its own account in Lehman Brothers during the summer before Lehman filed bankruptcy. The bank argued that it was entitled to make business judgments as to its own accounts and that those judgments need not be shared with customers. We were successful in arguing that the underlying market studies developed and relied upon by the bank in arriving at its decision to unload Lehman were material facts, and that its portfolio management oversight created a relationship of trust requiring disclosure. The bank ended up paying our client very substantial sums to cover the losses suffered after Lehman failed while the bank had paid itself large sums in advisory fees without sharing its research.
The takeaway point here seems to be that the bank acted improperly at least by its silence on the advisability of continuing to hold Lehman. It had information suggesting that holding the stock was a bad idea and the fiduciary duty of full disclosure trumped the “separate hats” distinction. Fair warning for multiple-role financial institutions, it seems.
- In a trial last year we sued a publicly-traded steel company when it decided to shift its internal profit sharing methodology between two of its wholly owned divisions. It claimed to be exercising a proper business judgment when it transferred income streams from one division to another in a way designed to attract the favorable attention of Wall Street investors (because of the optics of improved management). The problem was that one of those divisions was the majority partner in a partnership where our client was the minority, and the income being shifted came from business with the partnership.
The steel company argued that the business judgment rule allowed it to manage its divisions with wide discretion, and, in any event, that the majority had also been hurt proportionately to its percentage so there was no disparate impact. But we prevailed with a Superior court judgment that the steel company had abetted its majority owned subsidiary to breach the latter’s fiduciary duty to its minority partner in order to favor the parent. It was that favoritism that supplied the disparate impact: the majority partner arguably got an extra advantage because (unlike the minority) its parent gained extra benefits and thus the majority partner indirectly gained economic strength through increased corporate parent ballast.
- Another teaching point as to this latter trial relates to the fact that the defendant parent was represented by the same law firm as the majority partner. As a result, the defendant parent had a very difficult time arguing that it was insulated since the attorneys would then have had to take conflicting positions as to whether independent judgment was being exercised when the majority caused the partnership to agree to the shift.
- Yet another trial last year involved a legal malpractice claim against a law firm handling a complex alter ego claim for a client when the client fell way behind in its payments of legal fees. The law firm threatened to withdraw within a month of trial unless the client abandoned several claims it was maintaining against a third party, which claims were predicted to be expensive to litigate. The law firm contended the business judgment rule entitled it to make such a litigation decision and so it could not be held liable later when the client sued for the lost value of the abandoned claims. Our side prevailed in trial when the judge ruled that lawyers may not apply even the slightest pressure to a fiduciary client by threatening to withdraw on the eve of trial even if it was not getting paid.
The take-away point here is that business judgment in the form of litigation choices cannot be used for self-interested purposes. Forcing payment of fees/and or lessening the burden which the trial lawyers would have had to carry in order to prepare the alter ego case correctly were viewed as self-dealing.
The Business Judgment Rule is still alive in the fiduciary context, but the extremely high standards for fiduciary conduct severely limit its application whenever there are self-interested decisions which create a detriment.