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Courts Continue to Question Protections Afforded By Iconic Business Judgment Rule – Georgia Joins the Trend

7/21/14

By: Michael Wolak, III
The business judgment rule is an iconic fixture in American corporate jurisprudence reflecting a strong judicial reluctance to question the business judgments of directors and officers.  In its classic form, the business judgment rule insulates a company’s directors and officers from liability for negligence in the discharge of their fiduciary duties for mistakes in the exercise of honest business judgment.  The rule’s underlying rationale is that it is not the function of courts to second guess the business decisions of those who are entrusted with management of the affairs of the corporation, if they arrive at a decision for which there is a reasonable basis, they act in good faith and exercise independent judgment, and are uninfluenced by any consideration other than what they honestly believe is in the best interests of the corporation.
Several cases over the past few years, however, reflect a judicial trend towards questioning, and in some instances diluting, the scope of the rule’s protections.  For example, while most jurisdictions have uniformly applied the business judgment rule to both directors and officers, federal district courts in California have continued to follow the 2011 decision in F.D.I.C. v. Perry, 2012 WL 589569 (C.D. Cal. Feb. 21, 2012), which held that California’s common law and statutory business judgment rule applies only to directors, not officers.  See, e.g., F.D.I.C. v. Faigin, 2013 WL 3389490 (C.D. Cal. July 8, 2013).  The Perry court observed that California’s statutory codification of the business judgment rule does not mention “officers” and concluded that the legislative history suggests that the exclusion of officers was intentional because officers are more knowledgeable of the company’s operations and affairs than directors.  The hallmark of the business judgment rule, however, is that courts are not equipped to second guess the business decisions made by those who manage the company’s affairs, which includes directors and officers.  Thus, the underlying rationale for the rule clearly applies to both directors and officers.
Other courts continue to clarify and limit the scope of protection afforded by the business judgment rule.  For example, directors and officers typically could prove that a challenged decision was made with the requisite due diligence with evidence that they engaged the advice of outside consultants or experts to assist them in making an informed decision.  The Third Circuit Court of Appeals, however, reversed the grant of summary judgment to directors of a failed non-profit based on application of Pennsylvania’s business judgment rule, despite similar evidence of due diligence.  In Official Committee of Unsecured Creditors v. Baldwin, et al., 659 F.3d 282 (3d Cir. 2011), the district court relied on evidence showing that the directors engaged the advice of outside counsel and considered several options before making the challenged decision to file bankruptcy.  While acknowledging that this evidence could support application of the business judgment rule, the Third Circuit reversed and held that plaintiffs presented evidence demonstrating that the Board received several red flags as to the diligence and competence of two senior officers it relied on in making the decision to file bankruptcy, and eschewed a viability study.  This opinion underscores the need for directors and officers to ensure that each and every component of their decision is fully informed by all material facts available to them.
Georgia has now joined this growing trend of judicial questioning and clarification of the business judgment rule’s protections.  On July 11, 2014, the Georgia Supreme Court in F.D.I.C. v. Loudermilk, et al., (Case No. S14Q0454) answered the following question certified by Judge Thomas W. Thrash of the Northern District of Georgia:  Does the business judgment rule in Georgia preclude as a matter of law a claim for ordinary negligence against the officers and directors of a bank in a lawsuit brought by the FDIC as receiver for the bank?  In a comprehensive opinion written by Justice Keith R. Blackwell, a unanimous Georgia Supreme Court answered this question with a qualified negative, holding that “the business judgment rule precludes some, but not all, claims against bank officers and directors that sound in ordinary negligence.”  In enunciating a more “modest” business judgment rule, the Court first reaffirmed that the business judgment rule is a settled part of Georgia common law and that the rule has not been abrogated by Georgia statutory law.  While the Court made clear that the business judgment rule precludes ordinary negligence claims against officers and directors concerning “only the wisdom of their judgment,” the rule is not an absolute bar to ordinary negligence claims alleging that the challenged decision was made without deliberation or requisite due diligence, or in bad faith, thereby overruling Flexible Products Co. v. Ervast, 284 Ga. App. 178, 643 S.E.2d 560 (2007) and Brock Built, LLC v. Blake, 300 Ga. App. 816, 686 S.E.2d 425 (2009), which recognized an absolute bar against all claims premised on a want of ordinary care.  Although Loudermilk involved only bank officers and directors, the Court emphasized its desire to avoid “needless uncertainty” and overruled Flexible Products and Brock Built as to bank and non-bank officers and directors.
Whether other jurisdictions will be informed by the Georgia Supreme Court’s decision remains to be seen, but we can likely expect the FDIC and other plaintiffs litigating outside of Georgia to urge their respective courts to adopt the Georgia decision or to look to it for persuasive authority and guidance.  Here in Georgia (or cases in which Georgia law governs), the immediate impact of the decision is that it will now be more difficult for directors and officers to have ordinary negligence claims dismissed at an early stage, especially since sophisticated plaintiffs will not likely challenge merely the wisdom of the business decision.  Directors and officers may feel pressured to settle early to avoid the expense of discovery and protracted litigation, as well as the related risk and uncertainty of defending against mere negligence claims, as opposed to the higher standard of gross negligence.  In the meantime, any future expansion of the protections afforded to officers and directors in Georgia will have to be provided by the Georgia legislature.
If the judicial trend towards limiting the business judgment rule’s protections continues, directors and officers will continue to face increased liability exposure.  Whether or not this trend is short-lived, directors and officers should take appropriate steps to maximize the applicability of the business judgment rule to their future decisions, with the view that every business decision will be scrutinized in the future by disgruntled shareholders or creditors.  These steps should include, but are not limited to:

• Ensuring that each decision is made with due consideration of the interests of shareholders, creditors, and other interested parties
• Ensuring that each decision has the benefit of outside expert or other professional advice
• Ensuring that all available material facts are considered and the decision is informed by those facts
• Ensuring active participation by all directors, especially independent/outside directors
• Ensuring that all available options or alternative transactions are considered
• Ensuring that each decision is the product of active and comprehensive deliberation
• Ensuring that board minutes and other documents accurately memorialize the deliberations, considerations, judgment-calls, rejected alternatives, and written materials that inform the decision