"Business Judgment Rule" Protections Come With Requirements

09/01/2015 02:34 pm ET Updated Sep 01, 2016

The "business judgment rule" traditionally broadly protects corporate directors and officers from personal financial liability to shareholders and the corporation for making decisions that ultimately produce financial losses. The directors and officers cannot be expected to be infallible or to be guarantors of business success. A recent federal Court of Appeals decision for the Fourth Circuit, however, refused to provide unquestioned blanket business judgment protection to directors and officers of a failed bank for making bad loans and other mistaken actions. (FDIC v. Rippy). This comment briefly reviews the Fourth Circuit's decision.

In a brief and incomplete summary, the litigation arose after the Federal Deposit Insurance Corporation (FDIC) became a receiver of a failed North Carolina bank, Cooperative Bank. As is customary, the FDIC attempted to collect as many outstanding loans as possible and sued the bank's officers and directors for negligence, gross negligence, and breach of fiduciary duties for their lending and management decisions. The federal District Court applied the business judgment rule to shield the defendants from liability and the FDIC appealed to the Fourth Circuit.

The Fourth Circuit reversed the District Court's decision and remanded the case for a jury trial. In so doing, the Fourth Circuit discussed the business judgment rule.

The business judgment rule is state law and the Fourth Circuit reviewed North Carolina's provisions. Additionally, North Carolina allows directors to be protected from liability for negligence by exculpatory clauses (excusing from liability provisions) in the corporation's articles of incorporation (the document that creates the corporation). However, North Carolina law allows a finding of gross negligence without proof of deliberate or conscious action. The Fourth Circuit noted that Cooperative Bank's exculpatory clause did not eliminate directors' liability for breaches of the duty of loyalty or the duty of good faith, or gross negligence. Nor does the exculpatory provision include bank officers.

While there is a presumption that directors and officers act with due care on an informed basis in a good faith belief that their actions are in the best interest of the corporation, the presumption is not absolute. The presumptions underlying the business judgment rule may be rebutted (overcome) with evidence that the officers and directors "(1) did not avail themselves of all material and reasonably available information (i.e., they did not act on an informed basis); (2) acted in bad faith, with a conflict of interest, or disloyally: or (3) did not honestly believe that they were acting in the best interest of the [corporation]."

There was testimony that the officers did not follow generally accepted banking practices. For example, they approved loans over the telephone without examining relevant documents. The Fourth Circuit noted that while "it is convenient to blame the Great Recession for the failure of the [bank]," there is evidence that the bank officers could have "foreseen that some injury would result from [their] acts or omissions." These factual matters must be resolved by a jury.

The Fourth Circuit's decision is a clear signal to boards of directors and officers to be certain that they conform to generally recognized standards of conduct and that they carefully collect and review relevant information before making a decision. All of this should be documented in the corporation's records for future review. While it is tempting to rush to make a decision and be careless in record keeping, these lapses may impose personal liability when things go wrong.

This comment briefly reviews a single significant decision and is not intended to provide legal advice. Always consult an experienced attorney in all corporate and business matters.