Posted on: 10/19/2012
Joshua C. Webb, John Minett
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In two recent decisions, courts in California analyzed two statutes against the prospect of corporate officer liability, and have reached two very different outcomes. In FDIC v. Hawker, No. 12-0127, 2012 WL 2068773 (E.D. Cal. June 7, 2012), the court ruled that California's statutory business judgment rule could not be applied to absolve corporate bank officers from liability for alleged negligence and breach of fiduciary duty. On the other hand, in Sandler v. Sanchez, 206 Cal. App. 4th 1431 (Cal. Ct. App. June 18, 2012), the court determined that the California statute providing for the designation of a responsible corporate officer for real estate brokers, section 10159.2 of the Business and Professions Code, could not be used as the basis for making the designated corporate officer personally liable to third parties dealing with an agent of the brokerage.
Despite the differing results in these cases, the practical import of the results in these decisions and the analysis therein provides a meaningful reason to pause and consider the use of statutes in the practitioner's regular defense of corporate officers. Various state statutory provisions, when subjected to straightforward and practical analysis and application can operate as powerful defense mechanisms against liability for corporate officers, even in the face of an argument that the statutory provisions itself creates the putative liability, like the plaintiffs' claim in Sandler.
The decisions in Hawker and Sandler are summarized below with commentary on the courts' respective application of the statutory provisions under consideration, as well as some related points in conclusion for use in defending corporate officer liability claims.
FDIC v. Hawker and the Business Judgment Rule
In Hawker, the court was faced with the now not uncommon action by the FDIC as receiver for a failed bank against the institution's former officers for negligence and breach of fiduciary duty. The defendants, formers officers of County Bank, claimed that the business judgment rule barred the FDIC's claims and filed a Rule 12(b)(6) motion to dismiss.
The FDIC's action against the officers stemmed from what the FDIC described as $42 million in losses caused by "significant departures from safe and sound banking practices," more specifically for 12 real estate loans made by the institution that had focused on tract residential construction lending in the Central Valley. Hawker, 2012 WL 2068773 at *1. Each of the defendants was alleged to have responsibility for certain loan policies, as well as specific loan decisions, and each was a member of the bank's executive loan committee. Id. In sum, the FDIC alleged that the officer defendants were guilty of negligence and breaches of fiduciary duty by allowing the bank to make imprudent loans, particularly for risky construction and land development loans, and that the problems with the loans were further compounded when the loans were extended or renewed with no protection against declining collateral values. Id. With more detail, the FDIC claimed that the officers approved and permitted imprudent loans based on substandard evaluation, pursued unreasonable growth, failed to observe reasonable financial analyses, and did not require adequate underwriting and lending functions. Id. at *2.
Not surprisingly, the officer defendants characterized the underlying events and the bank's ultimate failure as attributable to "the colossal real estate and financial meltdown" that was entirely unpredictable at the time of the loans in question. Id. The officers moved to dismiss the FDIC's claims based upon the business judgment rule as precluding the imposition of personal liability against them, specifically noting the overlapping allegations of negligence and breaches of fiduciary duty that could not stand independent of one another. Id. at *2, 4.
Pursuant to 12 U.S.C. § 1821(k), the FDIC might have typically been limited to pursuing the officers for gross negligence – the floor for liability under that section of the Financial Institutions Reform, Recovery and Enforcement Act of 1989. However, the court noted that because simple negligence was a stricter standard as applied against the officer defendants under California state law and because the defendant's asserted immunity under the business judgment rule did not otherwise impact the section 1821 gross negligence standard, the analysis of liability was controlled by California state law. Id. at *4-5. As such, the defendants offered as their first line of defense the codification of the business judgment rule under Section 309 of the California Corporations Code. Id. at *5-6.
But the court rejected this argument on its face after recounting the statutory terms and related decisional authority while emphasizing the express references only to directors, and not officers. Id. The court stated that the California legislature had clearly omitted officers in the codification of the business judgment rule in section 309. Id. at *7. The court looked further at the legislative history of section 309, and confirmed that the Legislative Committee Comments pointed out that the standard for liability in the statute "does not include officers." Id. Thus, the court concluded that section 309 could not support the dismissal of the FDIC's claims against the defendant officers.
The court also did not permit the defendants to escape liability at the pleading stage by reliance on the broader component of the business judgment rule under the common law, by asserting that the FDIC's claims could go no further without allegations of fraud, bad faith, financial interest, or gross overreaching. Id. at *8. Despite the FDIC's attempt to have the court significantly curtail application of the common law rule to exclude officers again, the court relented and merely concluded that the business judgment rule was more aptly framed as an affirmative defense that raised fact questions and could not be resolve at the motion to dismiss stage. Id. at *9. The court rationalized its denial of the defendants' motion further by noting that the absence of allegations of fraud, etc. did not obviate the need for resolution of fact questions concerning business judgment later in the proceedings. Id.
Sandler v. Sanchez and Section 10159.2, California Business and Professions Code
In Sandler, the plaintiffs sued several defendant parties for breach of fiduciary duty arising out of a real estate loan transaction – the defendants included the borrower, a corporate real estate brokerage, and the individual designated officer/broker of brokerage, Carlos Sanchez. 206 Cal. App. 4th at 1435. The plaintiffs alleged that they were convinced to make a $600,000 loan to the borrower by an individual employed by the brokerage, who was also the principal of the borrower, but that the loan was made on the basis of a number of misrepresentations and half of the proceeds were used for personal expenses instead of the real estate project. Id. Without alleging any conduct specific to Sanchez, the plaintiffs' complaint sought to hold him personally liable for breach of fiduciary duty because he was designated officer of the corporate real estate brokerage under section 10159.2 of the California Business and Professions Code. Id.
Section 10159.2 makes the officer designated by a corporate broker licensee "responsible for the supervision and control of the activities conducted on behalf of the corporation by its officers and employees," and provides for certain administrative disciplinary measures if the responsibility for appropriate supervision is not met. Id. at 1437. In essence, the plaintiffs claim against Sanchez asserted that section 10159.2 created a duty to third parties for designated officers, and alternatively made an individual designated officer the principal of any corporate brokerage employee, and thereby personally subject to vicarious liability. The court rejected both of these contentions, affirming the trial court's dismissal of the plaintiffs' claim against Sanchez. Id. at 1435.
As to the first issue, the court determined that the language of section 10159.2 was ambiguous on its face in whether it created a duty and responsibility of supervision to third parties or simply the corporation itself. Id. at 1438. Fortunately for Sanchez, and unlike the court's examination of legislative history in Hawker, the court here found that the circumstances surrounding the enactment of section 10159.2 supported the defendant's position. Id. at 1438-42. The court conducted an exhaustive review of not only the legislative commentary, but also preceding and analogous decisional authority to support its conclusion that the statute, standing alone, did not create a duty to third parties, but was instead intended only to provide protection to the corporation itself. Id. The court noted that this intention was further demonstrated by the existence of the administrative disciplinary provisions created to accompany the responsibility for supervision.
The court next dispelled the idea that section 10159.2 could, by itself, make the designated officer of a brokerage an individual principal of the brokerage's corporate employees and subject to vicarious liability under the law of agency. Id. at 1442-45. In doing so, the court evaluated a combined trilogy of decisions from the Ninth Circuit and Supreme Court, adhering to the Court's rejection of "the contention that section 10159.2's supervisory duty itself created an agency relationship between the designated officer and the corporate broker's employees." Id. at 1445. Rather, the court in Sandler went further in agreeing with the implication from the decisions of the Supreme Court and the Ninth Circuit that only with additional factual circumstances showing an actual agency relationship between the individual designated officer and a particular corporate employee could the possibility of vicarious liability exist. Id. But the court held that the plaintiffs made no such allegations against Sanchez, rather their complaint tacitly admitted that he was not involved in the underlying events whatsoever.
In short, the plain lesson to be taken from the outcomes in Hawker and Sandleris that while certain state statutory provisions can provide important defensive measures against potential liability for corporate officers, careful evaluation of any such statute should be made before it is touted as a linchpin to the defense of a case. Despite the obvious policy behind protective statutory provisions, like the codification of the business judgment rule, only in the best case will the express terms will be explicitly coextensive with the underlying intent and policy.
In other cases, like Hawker and Sandler, the parties may assert or the court may determine that ambiguity exists in the statute or its application. When disparity exists between express statutory terms and underlying policy, the decisions in Hawker and Sandler demonstrate how important the resolution of that disparity can be in formulating the strategy for your defense of a case. For instance, while approximately 32 states follow some version of the Model Business Corporations Act, typically setting out standards of conduct and liability (as well as protections) for both directors and officers, if your jurisdiction doesn't have all or as many of those express provisions and protections, then a different perspective may inform your case strategy – from dispositive motions through discovery. On the other hand, in order to get an early understanding of your corporate officer client's potential exposure in a matter, an early court battle over the meaning of a particular statute and otherwise untested or unresolved theory of liability, like in Sandler, may be time well spent.
As a final note and aside, our D&O SLG is newly formed and actively seeking participants looking for substantive involvement. If you have interest in participating in publications and other work of the SLG, please reach out to me or the D&O SLG Chair, John Minett.
Joshua C. Webb
Hill Ward Henderson
John C. Minett
Endurance Services Ltd
New York, NY