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TUESDAY, JULY 12, 2016

PERSPECTIVE

A cautionary tale of Californias business judgment rule

By Stephen Ram

as directors approving their own

compensation), the challenged activity was taken because a director
is beholden to another person (such
as a directors approving compensation for an immediate family member
serving as CEO), or the challenged
activity amounts to bad faith (that a
director was derelict by consciously disregarding his duties). See In re
Cornerstone Theraputics, Inc., 115
A.3d 1173, 1179-80 (Del. 2015).
This amounts to substantial deference
because the courts start with the presumption that each director is acting
in good faith and for the best interests
of the corporation.
In Delaware, an officer or directors simple negligence is not actionable under the business judgment
standard of review. In addition, director liability is generally limited
to waste (actions with no corporate
benefit) because most corporations
have exculpatory charter provisions.
See Corwin v. KKR Fin. Holdings,
LLC, 125 A.3d 304, 312 (Del. 2015).
In California, the Parth court suggested that negligence remains actionable because the business judgement
rule seemingly requires a showing of
non-negligent conduct.

he decision in Palm Springs

Villas II Homeowners Association Inc. v. Parth, 2016 DJDAR
6013 (June 21, 2016), offers cautionary lessons that Californias business
judgment rule may only protect officers and directors upon their showing
of a diligent, reasonable investigation
before taking corporate action.
In Parth, the associations covenants, conditions and restrictions
(CC&Rs) and bylaws empowered the
board to enter into contracts and incur debts. However, the CC&Rs and
bylaws expressly limited those powers by requiring majority shareholder
approval for any contract longer than
one year and any debt encumbering the associations property. The
CC&Rs contained an exculpatory
provision that eliminated personal liability of any director acting in good
faith and without any willful misconduct.
Parth was the associations president and a director. After a suit by a
vendor, the association challenged
Parths actions, some taken by Parth
as president and others as a director.
The court did little to distinguish between those roles, even though the
charter and Corporations Code only Californias Rule May Protect Ulpermit exculpation for a directors tra Vires Actions
A corporation or association may
conduct.
hold its own fiduciary liable for ultra
The Business Judgment Rule Is an vires acts. Corp. Code Sections 208,
7141. The association argued that the
Affirmative Defense
The court treated the business judg- business judgment defense was not
ment rule as an affirmative defense, available for ultra vires acts in encumwhich many prior California deci- bering the associations property and
sions have done as well. Consequent- a threeyear contract, both of which
ly, Parth bore the burden to establish were without the required majority
that she made a reasonable inquiry shareholder approval. The court held
that these actions were not ultra vires.
as indicated by the circumstances.
However, other jurisdictions ap- Instead, the court accepted Parths
proach these issues differently. In contention that the business judgment
Delaware, the business judgment rule rule was available, but concluded that
is both an affirmative defense and the Parth did not establish the defense.
In Delaware, an act that exceeds
substantive standard of review for
a court to examine the challenged the authority vested by an unambiguconduct. Generally, the business ous charter, bylaw or similar governjudgment rule is the default standard ing instrument is ultra vires. Business
of review, unless the challenged ac- judgment review is not available. See
tivity amounts to self-dealing (such Cal. Pub. Emps. Ret. Sys. v. Coulter,

2002 Del. Ch. LEXIS 144, at *40

(Dec. 18, 2002). Shareholders should
reasonably expect officers and directors to respect the defined powers entrusted to them.
Insights into Best Practices for Officers and Directors
The Parth court ultimately reversed
and held that triable issues existed on
Parths reasonable investigation. For
example, the associations common
areas were in need of roofing repairs.
Parth contacted the associations former roofer, but learned that company
went out of business. Based upon a
referral, Parth contacted a licensed
contractor, Warren Roofing. The
board retained Warren Roofing, albeit
without a bid or contract, and Bonded Roofing (also licensed) apparently
served as the project manager. The associations expert opined that roofing
invoices were inflated, the work was
deficient, and roofs needed repairs
later. At deposition, Parth was confused and unable to explain the relationship between Warren Roofing and
Bonded Roofing.
The court found that Parth had not
established an adequate investigation. However, there was uncontested
evidence that Parth recognized the
roofing problem, Parth obtained a
referral for a licensed contractor, and
the board approved the retention. Assuming that Parth was negligent for
not doing more, the business judgment rule should still have applied for
Parths mistaken, yet good faith acts.
Parth would have been in better
position if she had contemporaneous
evidence of soliciting bids from multiple roofing contractors; a documented investigation of each potential
roofers references, licensing, bonding, and insurance; board minutes
reflecting the discussion and decision
to engage the ultimate roofer; and a
written contract or signed work order.
The reasonableness of an investigation will depend on the circumstances; documentation should accurately
reflect the greater investigation and
discussion for material actions.
Parths investigation also should

have included advice from the property management company. Officers

and directors should use outside consultants and counsel for advice on the
business merits of potential actions
and their fiduciary duties as part of a
reasonable, defensible investigation.
As another example, the associations contract with its security service expired, and the service worked
month-to-month. Parth as president
renewed the contract for another year,
but either forgot or failed to inform
the entire board. The court found that
Parths deposition testimony inconsistent on her authority to enter into
association contracts. However, the
court did not consider the charter or
bylaws provisions for the presidents
powers to enter into association contracts.
The court was understandably dismayed that Parth had little familiarity with the charter and bylaws. The
organizational documents are a key
component for deposition preparation, along with preparation for each
of the challenged actions, her investigation, her reasons for that investigation, decision making, and any known
negative evidence.
Directors and officers of California
companies or companies subject to
suit here can benefit from Parths loss
to ensure their actions comport with
Californias business judgment rule.
Stephen L. Ram is a shareholder
in Stradling Yocca Carlson & Rauth
PCs business litigation and securities litigation practices representing
a broad range of clients from startups
to public companies.

STEPHEN RAM

Stradling Yocca Carlson & Rauth

Reprinted with permission from the Daily Journal. 2016 Daily Journal Corporation. All rights reserved. Reprinted by ReprintPros 949-702-5390.