The best way for a company’s directors and officers (collectively, “Executives”) to protect themselves from personal liability is to discharge their responsibilities in good faith, with reasonable diligence, and with full disclosure of any conflicts of interest that could affect their judgment.

Our recent practice group newsletters have focused on the legal mechanisms, such as indemnification and exculpatory clauses, available to protect directors and officers from personal liability. This month’s newsletter takes a step back and focuses on the basic legal framework for Executive liability. The short hand for this legal framework is the business judgment rule: the legal system will not impose liability on Executives for bad business decisions so long as the Executives subjectively believed they were acting in the company’s best interests, the Executives followed a rational decision making process, and the Executives acted without conflicts of interest. A recent case from the banking industry illustrates how this rule works to protect Executives.

The facts of the case relate to one of the many banks that failed in 2009 due to bad real estate loans. The North Carolina Commissioner of Banks declared Cooperative Bank insolvent and named the FDIC as the bank’s receiver. As receiver, the FDIC stepped into the shoes of the bank and its former shareholders. The FDIC then sued the bank’s former Executives for negligence, gross negligence and breach of fiduciary duty in their operation of the bank.

The FDIC’s lawsuit related to the approval of 86 loans made between January 5, 2007 and April 10, 2008. The FDIC alleged that the former Executives approved these loans in violation of (i) regulatory criticisms and warnings related to underwriting standards, (ii) the bank’s loan policy, (iii) published regulatory guidelines, and (iv) generally established banking practices.

The Executives responded that the business judgment rule protected them from personal liability because they had acted in good faith, after reasonable consideration of relevant information and the company’s best interests, and without conflicts of interest. As evidence, the Executives introduced facts showing that the Executives had determined that the bank needed to grow to stay viable and had determined to make the challenged loans in deliberate pursuit of the growth strategy. In addition, the Executives noted that the FDIC itself that rated the bank as a 2 (the second best grade available on the 1-5 scale used by banking regulators).

Upon review of this evidence, the court held that the Executives could not be held liable for their actions because they had met the standard of conduct required by the business judgment rule: they acted in good faith, in the company’s best interest based on a rational consideration of the risks, and without conflicts of interest. In the court’s words:

“Although there were clearly risks involved in Cooperative’s approach, the mere existence of risks cannot be said, in hindsight, to constitute irrationality. Further, corporations are expected to take risks and their directors and officers are entitled to protection from the business judgment rule when those risks turn out poorly. Where, as here, defendants do not display a conscious indifference to risks and where there is no evidence to suggest that they did not have an honest belief that their decisions were made in the company’s best interests, then the business judgment rule applies even if those judgments ultimately turned out to be poor.”

FDIC v. Willets, No. 7:11-CV-165-BO, slip op. at 9 (E.D.N.C. Sept. 10, 2014) (emphasis added).

The Willets decision, thus, reaffirms the business judgment rule: a court will not second guess business decisions made in good faith, in the company’s best interests, with reasonable information, and without conflicts of interest.