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California Court of Appeals Finds that Business Judgment Rule Will Not Protect Board Decisions that Contravene Corporation’s Private Contractual Obligations: Scheenstra v. California Dairies, Inc.

signing contract.jpgA recent California Court of Appeal decision highlights that a board of director’s discretion under the business judgment rule is by no means absolute. The “business judgment rule” (“BJR”) generally protects a corporate director from his or her business decisions when made in good faith, with due care and inquiry, and in a manner the director reasonably believes to be in the company’s best interest. The rule is based on the fact that the directors, not the courts, are in the best position to determine whether a particular act is beneficial to the organization. However, this does not mean that directors are protected from all decisions they make that turn out badly.

In fact, in January of this year, the California Court of Appeal affirmed the trial court’s decision, finding that California Dairies, Inc.’s (“Cal Dairies”) board of directors (the “Board”) exceeded its discretion when it instituted a quota system that breached its contractual obligations to its members. Plaintiff John Scheenstra was a member of Cal Dairies, a member-owned milk marketing and processing cooperative. Any time a member joins the cooperative, he or she agrees to be bound by the cooperative’s bylaws, which thereby creating a contract between Cal Dairies and each of its members.

In 2007, the Board established an internal quota system based on the discretionary authority granted to it in its bylaws to institute such a system. The system was put in place to reduce milk production in anticipation of overproduction. When the Board instituted this system, it was aware that there was an industry-wide oversupply of milk and that other cooperatives had adopted similar programs to reduce milk production by its members. Claiming that the quota was too low and was causing him hardship, Scheenstra subsequently filed suit against Cal Dairies alleging, among other things, breach of contract. He relied on a contract provision that obligated Cal Dairies to implement a quota system equitably and on a uniform basis based on representative years of production. The trial court sided with Scheenstra and found that the BJR did not shield Cal Dairies from liability for breach of contract.

Cal Dairies appealed and the Court of Appeal granted review, focusing on, among other things, whether the Board could seek the protection of the BJR and whether it acted within the scope of its discretionary authority. The court concluded that Cal Dairies could seek the protection of the California BJR since it is organized as a corporation.

Resolution of the second issue, however, was not as straightforward, and required considerable analysis by the court. Though California’s BJR has two parts, only one part was applicable here. As a result, the court looked only at the common law part of the rule which insulates from court intervention those management decisions, made in good faith, by directors based on what they believe is in the organization’s best interest. In this case, the management decision at issue–establishing a milk production quota system–was also subject to a contract between Scheenstra and Cal Dairies. Specifically, even though the contract granted discretion to the Board on matters involving business operations, it also limited that discretion by placing certain restrictions on any quota system that would be adopted.

Under these circumstances, where a contract placed certain limitation on the Board’s discretion, the court concluded that it had to determine whether the Board’s action was authorized by the contract before it could decide whether the Board’s decision would be afforded deference under the BJR. After undergoing a thorough interpretation of the language of the contract and determining that Cal Dairies’ quota program breached its contract with Scheenstra, the court concluded that the BJR did not apply to the Board’s action.

This case emphasizes the principle that the BJR does not allow a board of directors to rewrite a contract to expand its own discretionary authority and diminish the contractual rights and protections given to the other party to the contract. It is important to remember that only corporate directors, and not corporate officers, are entitled to the heightened protections of the BJR. If you have any questions about this case or whether your business decisions are protected by the business judgment rule, our Pleasanton business litigation attorneys can help. You can contact one of our business litigation lawyers who can assist you in protecting your interests in business disputes using our online contact form, or by calling us at 925-463-1073.