Fourth Circuit Holds Business Judgment Rule Does Not Protect Corporate Officers Who Fail to Act in an Informed MannerPDF
On August 18, 2015, the Fourth Circuit Court of Appeals held in Federal Deposit Insurance Corporation ex rel. Cooperative Bank v. Rippy, No. 14-2078, that North Carolina’s business judgment rule does not protect bank officers from liability where evidence reveals that the officers may have failed to act in an informed manner when approving loans. The Fourth Circuit also rejected the officers’ fallback argument that the bank’s collapse was the product of the “Great Recession” rather than the officers’ conduct. While the court re-affirmed the business judgment rule in North Carolina, it concluded that the record (much of which was filed under seal) included evidence sufficient to permit a trier of fact to conclude that the officers had not acted on an informed basis and therefore were not entitled to the presumptions under the business judgment rule. Accordingly, the Fourth Circuit reversed the lower court’s award of summary judgment in favor of the officers. Although Rippy may be limited to the unique facts at issue in the case, taken at face value, the Fourth Circuit’s holding demonstrates that corporate officers will lose the protection of the business judgment rule if they fail to act in an informed manner and may be monetarily liable for resulting injuries, even if a general economic downturn contributes to the those injuries.
The Rippy case arose out of the June 2009 collapse of North Carolina-chartered Cooperative Bank (“Cooperative”). Cooperative, which operated 23 branches from the Outer Banks to Myrtle Beach, historically concentrated on single-family housing loans. By the mid-2000s, the bank had begun to focus on growing its commercial real estate lending operations.
Between 2006 and 2008, Cooperative’s regulators and external loan reviewers conducted several examinations of the bank’s operations and loans. While the examinations uncovered certain “deficiencies” in Cooperative’s operations and loan review process—particularly with respect to oversight and risk management—the bank generally earned favorable marks.
Cooperative’s apparent health changed as the Great Recession accelerated in the second half of 2008. In June of that year an external loan reviewer criticized Cooperative for failing to document and monitor certain loans. In November the FDIC issued a report that was extremely critical of Cooperative’s operations, faulting the bank’s decision to focus heavily on commercial real estate lending.
After issuing its November 2008 report, the FDIC developed a capital restoration plan in an attempt to shore up Cooperative’s finances. With the Great Recession in full swing, however, Cooperative was unable to comply with the terms of the capital restoration plan. On June 19, 2009, the North Carolina Commission of Banks closed Cooperative and appointed the FDIC as the receiver. The FDIC estimated that it suffered losses of $216.1 million due to Cooperative’s collapse.
The Rippy Lawsuit
The FDIC sued Cooperative’s directors and officers in 2011, alleging that the defendants’ approval of certain residential and commercial loans amounted to negligence, gross negligence, and/or breach of fiduciary duties. After a lengthy discovery period, the District Court granted summary judgment to the bank’s directors and officers. The District Court ruled that North Carolina’s business judgment rule barred the negligence and breach of fiduciary duty claims where there was no evidence that the defendants engaged in self-dealing, fraud, or other unconscionable conduct amounting to bad faith. The District Court also determined that the gross negligence claim failed absent evidence that the directors and officers acted with the knowledge that their conduct would harm the bank.
The Fourth Circuit’s Decision
The Fourth Circuit reversed the District Court’s grant of summary judgment to Cooperative’s officers with respect to the negligence and breach of fiduciary duty claims. According to the Fourth Circuit, a reasonable jury could determine that Cooperative’s officers forfeited the benefit of the business judgment rule by failing to make lending decisions in an informed manner.
North Carolina’s business judgment rule:
operates primarily as a rule of evidence or judicial review and creates, first, an initial evidentiary presumption that in making a decision the directors acted with due care (i.e. on an informed basis) and in good faith in the honest belief that their action was in the best interest of the corporation, and second, absent rebuttal of the initial presumption that a decision by a loyal and informed board will not be overturned by a court unless it cannot be attributed to any rational business purpose.
Slip. Op. at 16 (quoting Russell M. Robinson, II, Robinson on North Carolina Corporation Law § 14.06, at 281 (5th ed. 1995)). The “initial evidentiary presumption,” the Fourth Circuit explained, may be rebutted with evidence that corporate officers or directors (1) failed to act on an informed basis (i.e. “did not avail themselves of all material and reasonably available information”); (2) acted in bad faith, with a conflict of interest, or disloyalty; (3) did not honestly believe they were acting in the best interest of the corporation.
Applying that standard, the Fourth Circuit determined that evidence in the record created a jury question whether Cooperative’s officers acted on an informed basis when making the lending decisions challenged in the lawsuit. The FDIC presented an expert affidavit and report from an independent banking consultant who opined that Cooperative’s officers did not act in accordance with generally accepted banking practices. Among other concerns, the FDIC’s expert identified instances in which Cooperative’s officers “approved loans over the telephone” without reviewing relevant loan documents. The Fourth Circuit also discounted the significance of Cooperative’s high marks from regulators in 2006 and 2007, noting that the regulators’ reports contained indications that the bank’s credit administration needed “substantial improvement.” As a result, the Fourth Circuit held that a reasonable jury could decide that the FDIC’s evidence would be sufficient to rebut the presumption that Cooperative’s officers acted on an informed basis.
The Fourth Circuit also rejected the bank officers’ fallback position that the FDIC failed to present evidence that the officers’ conduct, rather than the Great Recession, proximately caused the FDIC’s claimed injury. The Court acknowledged that the Great Recession contributed to the failure of the bank, but the Court determined that North Carolina law permits multiple proximate causes of any injury. So long as the officers could have foreseen that “some injury” would result from their actions or omissions, their conduct could amount to a proximate cause notwithstanding the fact that some of the FDIC’s injury was the result of the Great Recession.
The Fourth Circuit generally affirmed other aspects of the District Court’s ruling. In particular, the Court concluded that an exculpation clause in Cooperative’s articles of incorporation shielded the bank’s directors from liability arising from a breach of the duty of due care. The Court also affirmed the grant of summary judgment to all defendants on the FDIC’s gross negligence claim in the absence of evidence of “wanton conduct done with conscious or reckless disregard for the rights and safety of others.”
Although this suit was brought by the FDIC and a decision by the Fourth Circuit interpreting state law is not binding on North Carolina courts, plaintiffs attempting to overcome the business judgment rule in other suits against officers and directors of North Carolina corporations will certainly cite Rippy. Their success will largely depend on whether directors and officers can persuade courts that the particular facts of the Rippy decision limit its significance and impact. Currently, the critical facts are not publicly available because much of the evidence in this case has been submitted under seal, including the expert’s report crucial to the Fourth Circuit’s decision. Nonetheless, corporate actors, particularly in the banking and lending industries, should consider steps to insulate themselves from potential liability for business decisions:
- Corporate officers and directors should review all material and reasonably available information before making decisions affecting the corporation to avoid losing the protections of the business judgment rule; and
- Executives should not conclude that a regulator’s general approval of a bank’s operations will insulate them from liability under the business judgment rule where evidence indicates that the executives acted without due care in particular instances.
Furthermore, corporate actors should keep in mind that claimants harmed by uninformed business decisions may be able to show a causal link between these negligent decisions and damages to a third party even if larger economic forces, such as the Great Recession, undoubtedly played a role in the complainants’ harm.