A federal court in Los Angeles has recently issued a decision that removes an important protection against liability for corporate officers of companies that operate in California. In FDIC v. Perry, No. CV 11-5561 ODW (December 13, 2011), Judge Otis Wright II ruled that, under California law, the business judgment rule is not a bar to a claim by the Federal Deposit Insurance Corporation against the former Chief Executive Officer of IndyMac Bank. 

IndyMac was a home mortgage lender that was closed and placed under FDIC receivership in 2008, due to the collapse of the mortgage backed securities market and the increasing rate of default on home loans it had originated. Ultimately its assets were liquidated by the FDIC, which incurred losses of approximately $600 million. In July 2011, the FDIC sued Matthew Perry (who was the CEO of IndyMac until its seizure) for negligence in permitting the production of a pool of more than $10 billion worth of risky home loans that it was ultimately not able to sell into the secondary mortgage market and had to retain as investments.  In its complaint, the FDIC alleged that Perry was aware of the deteriorating condition of the secondary mortgage market as well as problems with the quality of the loans originated by IndyMac and thus breached his duties to the corporation in permitting the origination and purchase of loans that caused the losses to the FDIC. Importantly, the case rests solely on Perry's negligence and not any allegations of fraud, bad faith or self-dealing.

Perry moved to dismiss the FDIC lawsuit, contending that the business judgment rule compelled dismissal of the complaint for failure to state a cause of action, under Federal Rule of Civil Procedure 12(b)(6). The FDIC countered that the business judgment rule protects only directors of corporations and that it should be allowed to proceed with its claims for negligence against Perry in his capacity as the Chief Executive Officer. Judge Wright denied the motion to dismiss.

Perry's lawyers argued that as a matter of common law the business judgment rule has evolved to protect the actions of officers as well as directors who act in good faith, notwithstanding the fact that statutes such as California Corporations Code § 309 mention only  directors and not officers. Several cases in California and in other states, including Delaware, have treated officers and directors together in discussing the protection of reasonable, good faith business judgments. The defense also asserted that at core the FDIC complaint was based on the premise that Perry had overseen a flawed business strategy at IndyMac and the complained-of actions were taken in his role as Chairman of the Board of Directors and not as Chief Executive Officer. As a consequence, even if the reach of the business judgment rule was limited to directors, Perry should still be entitled to its protection.

The FDIC contended, and Judge Wright agreed, that there were policy and historical reasons for limiting business judgment rule protection to directors alone. While the judge acknowledged that some California cases could be read to include officers within the ambit of  the business judgment rule, this was inconsistent with both the statutory history of California's Corporations Code and a leading case which had confronted the issue directly. Relying on the work of Harold Marsh, who was the principal draftsman of the modern California Corporations Code, the Perry court concluded that the enactment of Corporations Code § 309 represented a codification of the common law business judgment rule and the exclusion of officers from coverage under the statute was intentional. As a consequence, the court was unwilling to import any meaning to the statute beyond the specific language. Further, the court disagreed with the characterization of Perry's actions as those of a director, rather than an officer, and denied the application of the business judgment rule on that basis. 

Judge Wright also relied heavily on the decision in Gaillard v. Natomas Corp., 208 Cal. App.3d 1250, 256 Cal. Rptr. 702 (1^st Dist. 1989) to support the conclusion that Perry was not protected by the business judgment rule. Gaillard was a shareholder derivative action challenging the award of golden parachutes to key executives (some of whom were directors) of Natomas Corporation in the context of a takeover battle. Relying on Marsh's treatise, the Gaillard court concluded that the insider directors (who did not vote on the parachutes) were not entitled to protection of the business judgment rule on the premise that they were acting not as directors, but as officers, and therefore were outside of the coverage of Corporations Code § 309. The Gaillard decision has been criticized for flaws in reasoning—among other things, the insider directors should not have been entitled to business judgment protection on the basis that  they were beneficiaries of the parachutes and the court's decision to characterize them as officers was unnecessary—but it remains the leading case decided by a California appellate court on the question of the reach of the business judgment rule.

It is important to note that the ruling in FDIC v. Perry comes at an early stage of the proceedings—a motion to dismiss prior to the filing of even an answer to the complaint—but the decision to deny Perry the protection of the business judgment rule invites a level of judicial inquiry into business decisions that would not be welcomed by most executives. In addition, it is not clear what standards will be applied by the court to assess Perry's conduct as an executive officer of IndyMac. Normally the application of the business judgment rule would preclude a finding of liability based on mere negligence, but by denying Perry the protection of the rule, it will be necessary for the court to establish a standard for liability.  

A curious feature of the case is that IndyMac was a Delaware corporation and yet there were no arguments made by either side, or any consideration given by Judge Wright, as to why California corporate law, as opposed to Delaware law, should govern the case. Delaware law provides officers as well as directors with the benefit of the business judgment rule and would have compelled a different result.  While California's "pseudo foreign corporation statute" (Corporations Code § 2115) would displace Delaware law in favor of California law where Corporations Code § 309 is implicated, Corporations Code § 2115 should not apply in this case, as IndyMac was a publicly traded company and thus exempt from that law.

The result in FDIC v. Perry should concern executive officers of California corporations and corporations organized outside California that have a presence in the state. Without the availability of the business judgment rule as a bedrock defense, corporate officers now will face potential liability for good faith business decisions based on a finding of negligence, which will be evaluated under standards that have yet to evolve in case law. The failure of the court to consider the appropriateness of applying California law in this context raises the very real prospect that officers of companies organized outside California with a presence in this state may also be subject to negligence claims, which will be determined under California law, rather than the law of the jurisdiction of incorporation.

This article was prepared by Andrew J. Demetriou (ademetriou@fulbright.com or 213 892 9338) and Michael T. Clark (mclark@fulbright.com or 213 892 9382) from Fulbright's Corporate Governance Practice Group.