Article Archives >> Lead Stories >> May 1-15, 2008

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Business Judgment Rule Protects
Some, But Not All, Directors
Court allows suit to proceed against director
who allegedly had personal interest in Board’s decision

A federal District Court in Arizona has dismissed breach of fiduciary duty claims against six of seven directors of a nonprofit corporation who participated in a decision to start suit against some detractors of the organization. 

Five were dismissed because they were protected by the “business judgment rule.”  A sixth was dismissed because she had voted against bringing the suit.  And a seventh was not dismissed, and was required to defend, because he allegedly had a personal interest in the matter that prevented him from relying on the presumption of good faith action.  (Best Western International v. Furber, D. AZ, No.CV-06-1537-PHX-DGC, 5/12/08.)

The case involves litigation originally brought by Best Western International, Inc., an Arizona nonprofit corporation whose members own and operate hotels under the “Best Western” brand name.  BWI sued several unnamed John Doe defendants, claiming they posted anonymous messages on an Internet website that, among other things, defamed BWI, breached contracts with BWI, revealed confidential information, and constituted unfair competition. BWI subsequently amended the complaint to name several individual defendants whose identities they had learned through discovery.

One of the defendants, James Dial, counterclaimed against BWI and its seven directors, claiming that BWI had committed abuse of process and intentionally interfered with his contract, and that the directors had breached their fiduciary duties and aided and abetted abuse of process.  The corporation and the directors sought summary judgment to dismiss the counterclaims.

The business judgment rule, the Court said, “precludes judicial inquiry into actions taken by a director in good faith and in the exercise of honest judgment in the legitimate and lawful furtherance of a corporate purpose.”  There is a “presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action was in the best interests of the company.” 

It said “a showing of gross negligence is necessary to strip the director of the rule’s protection.”  But “where there is a prima facie showing that a director is personally interested in a corporate transaction, … the burden shifts to the director to show that the decision with respect to a particular transaction is fair and serves the best interests of the corporation.”

The directors in this case were in several different positions.  The claim against one director was dismissed because she had voted against bringing the original litigation and obviously could not be responsible even if the suit was a breach of fiduciary duty.

Two directors testified that they voted for the suit in good faith and on the advice of the corporation’s counsel because they believed that discovering the identities of those involved with the website would be in the best interests of the corporation.  Once they learned that members, rather than competitors or disgruntled employees, were involved with the site, they voted against continuing the lawsuit.

The defendant did not contend that the two had a personal interest in the litigation or acted in bad faith.  Rather he asserted that the directors were “kept in the dark” by the BWI bureaucracy and should not be protected because their decision to pursue the action was not informed.

But Dial presented no evidence that the directors’ reliance on the advice of counsel was unreasonable, the Court said, and the business judgment rule applied.  Even if they were kept in the dark, there was no evidence of gross negligence.

Three directors testified that they believed in good faith that bringing and pursuing the claims was in the best interests of the corporation.  Dial argued that they breached their fiduciary duty by not making their own independent investigation and relying only on the work of counsel.  The Court said there was no evidence of gross negligence in that reliance.

With regard to the seventh director, Dial claimed that the director had threatened to sue Dial for damages if Dial did not cease making alleged defamatory statements against him.  Two of the other directors testified that the seventh director had said he would personally benefit from learning the identities of the website operators because he believed he had a defamation claim worth $600,000 - $700,000.

Because of the allegation of personal interest, the business judgment rule did not apply and the burden shifted to the director to show that his actions were fair and in the best interests of the organization.  Since he had made no such showing, the Court said, summary judgment dismissing the claim was denied.

The Court also found that the original lawsuit was not an abuse of process and that the claims of aiding and abetting were therefore moot.  The Court allowed the counter-claim to proceed against the corporation for interference with contractual expectancy because there was conflicting evidence on whether BWI had inadvertently or intentionally removed Dial’s hotel from the reservation system.

YOU NEED TO KNOW

The business judgment rule is a state law concept and may be stated slightly differently from state to state.  But it generally protects directors who act in good faith, with ordinary prudence (or without gross negligence), and in the best interests of the corporation.  In making their decisions, they are generally allowed to rely on professional advisors, board committees, and staff so long as they have no reason to believe that they are unreliable.  

Notice that the rule protected here both those directors who voted for the suit and then sought to end it when they found out who was involved, and those directors who voted for it and wanted to continue.  They all relied in good faith on the advice of counsel on the critical question of whether to bring the litigation in the first place.

Although this case involves a nonprofit with a more commercial purpose than most, the rule generally applies to both for-profit and nonprofit corporations.

Article Archives >> Lead Stories >> May 1-15, 2008