What is the Business Judgment Rule in California?
In the recent case of Tuli v. Specialty Surgical Center of Thousand Oaks, LLC, the California appellate court reviewed the business judgment rule.
Randhir Tuli is not a medical doctor, but he helped form a medical business. For a time, Tuli contributed to the enterprise, but then he lapsed into inactivity: he did nothing productive. He did, however, keep taking millions from the enterprise’s profits.
His hardworking surgeon colleagues in this business became restive and sought to buy him out, but Tuli refused to surrender his lucrative perch.
Then Tuli directed his lawyer to send an aggressive—and fateful—letter to a wide swath of recipients, including potential investors in the surgical business. The letter was professionally designed to be scary. It suggested the specter of criminal liability for all involved. Tuli had no good faith belief in the factual or legal basis for his specious claim.
In response to his baseless and damaging letter, others in the limited liability company warned Tuli they would eject him without compensation, as was their right, unless he cured the situation within 30 days. Tuli spurned their offer.
The surgeons made good on their ultimatum: they put Tuli out and paid him nothing.
Tuli launched a decade-long litigation campaign against his former business colleagues. The trial court rejected all Tuli’s claims and the appellate court affirmed.
From 1997 to 2005, Tuli and defendant Dr. Andrew Brooks worked together to create a group of surgery centers. Tuli was an experienced and sophisticated entrepreneur whose ventures had won him millions of dollars.
These centers created lower cost alternatives to hospitals: they eliminated a costly intermediary between surgeon and patient.
The corporate form of ownership for each center was a limited liability company. Specialty was a limited liability company. An operating agreement governed its activities.
In 2005, a Tennessee entity we will call Symbion paid Brooks and Tuli over $16 million each to buy their interests in every center except the Specialty location.
Tuli, Brooks, and Symbion set up Specialty to be a pass- through entity. Specialty did not accumulate retained earnings.
Every month, it distributed to members all the revenue it collected from recent surgeries. The idea was to convince the member surgeons that this was an attractive and immediately profitable place for them to conduct surgeries.
Specialty’s only real asset was its members’ entitlements to get a share of the revenues from future surgeries. Its one asset was prospective only.
There was no publicly traded market in Specialty’s shares. Tuli and Brooks had designed Specialty to be a closed and selective organization; they wanted complete control over the surgeon investors they would solicit and would accept for membership in their elite and highly profitable firm. It took a lot more than just money to become a Specialty member.
A central feature of each version of Specialty’s operating agreement was the provision about a “terminating event.” The terminating event provision was designed to ensure “bad actors” within the company did not damage it. The founders sought to prevent an insider from destroying the business.
They “spent a lot of time negotiating” the terminating event provision. They discussed it in detail with each other and with potential physician members.
A “terminating event” would occur when a Member has disrupted the affairs of the Company or has acted adversely to the best interests of the Company, as determined in the reasonable discretion of the Governing Board, and fails to cure such conduct within thirty (30) days after receipt of a written notice of such conduct sent by the Governing Board to such Member.
The pertinent consequence of a terminating event was loss of the offending member’s Specialty shares.
Friction arose at Specialty when Tuli wandered off the job—permanently. By the end of 2007, Tuli had completely abandoned Specialty.
Tuli’s inactivity at Specialty caused consternation to its doctor members. Their work generated all of the revenue. By contrast, Tuli’s productive effort was zero, but he continued to get 11.3% of the take.
At the time of the dispute, for instance, Specialty was distributing over a million dollars a year to Tuli for nothing in return.
In 2010 and 2011, Goodwin, on behalf of the physicians at Specialty, offered to buy Tuli’s interest. Tuli refused, claiming their offer was an “unfair lowball price.” He wanted more money.
On February 13, 2014, Tuli took his fateful action. He directed his attorney to send a threatening letter. Tuli’s decision prompted Specialty to oust him from the company.
The cover note warned that “[f]ailure to do so may expose you to individual liability.”
Tuli’s saber rattling backfired. Specialty ejected him from the company without compensation. Tuli responded with this lawsuit, which is now more than ten years old.
Specialty ousted Tuli in March 2014. It redeemed Tuli’s ownership shares for zero dollars and ended his participation in the company.
The fundamental principle governing this case is the business judgment rule.
This rule is a presumption that the directors of a corporation make business decisions on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company. Courts defer to board judgments that can be attributed to any rational business purpose.
The parties did not dispute that this rule applies to limited liability companies as well as to corporations.
The trial court ruled the business judgment rule insulated Specialty and its decisionmakers from Tuli’s claim they breached their fiduciary duty to him.
The court found Specialty established this affirmative defense by proving its business purpose was rational: Specialty sought to continue to use private offerings to raise capital without baseless allegations of illegality and impropriety from an existing shareholder.
The evidence supported Specialty’s rational fear that Tuli’s letter would scare off potential investors, that it was rational to notify Tuli his letter was a terminating event, and that it was rational to oust him when he refused to cure within 30 days of Specialty’s notice.
Tuli contended the business judgment rule should not apply to his case for three reasons: conflict of interest, bad faith, and improper investigation.
Tuli claimed a conflict of interest infected the governing board’s decision making, which Tuli maintained made it error to apply the business judgment rule to this case.
The conflict-of-interest exception to the business judgment rule arises when the interests of the individual decisionmakers diverge from the interest of the enterprise as a whole.
A classic example is when directors, faced with a merger, adopt defensive measures but might be acting to protect their own interests rather than those of the corporation and shareholders.
This situation sparks the fear the individual decisionmakers are not to be trusted, for they might be serving their self-interest at the expense of the interests of the entity and its owners, like the shareholders. When the decisionmakers’ personal interests conflict with the enterprise’s interests, the business judgment rule does not apply.
The uncontested evidence in this case, however, was that Specialty’s decisionmakers worked in the best interest of the company as a whole.
Tuli also argued the business judgment rule did not apply because bad faith and improper motives drove the governing board to be rid of him.
“Bad faith” is a common law term in corporate law with an indefinite meaning.
“The black letter requires that officers and directors act in good faith to receive the protection of the business judgment rule. The term ‘bad faith’ is used extensively in corporate law, and the extent to which its meaning varies depending on the context in which it is used is unclear. . . . Illegal conduct may constitute bad faith, and courts have generally stated that the business judgment rule does not apply to knowingly illegal conduct.”
Tuli argued Goodwin, Brooks, and “the other Defendants” exhibited “extreme animosity against Tuli.” “They had been ‘extremely upset’ with Tuli for a long time, were frustrated that he was earning high profits without bringing in business or providing services, and had repeatedly and unsuccessfully tried to buy his units.”
It is not bad faith to offer to buy out an unproductive element, as Tuli conceded. He admitted there was nothing wrong with offering to buy his shares.
Nor is it corporate bad faith for company decisionmakers to be frustrated with a corporate team member who is earning “high profits,” as Tuli phrased it, for doing nothing.
The appellate court saw no logic in adopting this position, which is at odds with the notion that corporate decisionmakers should be working to maximize enterprise value for the benefit of corporate owners.
The objective of a corporation is to enhance the economic value of the corporation.
In any organization, emotions sometimes can run high. After one business person attacks another before an audience of associates, without a good faith basis, it would be not unusual for the victim to scorn the attacker.
Tuli supplied no precedent for extending the concept of bad faith to a situation where a company decisionmaker, while working in the company’s best interests, privately disparaged a colleague.
Tuli made a third argument as to why the business judgment rule does not apply: Specialty, he claims, did not properly investigate the charge in his letter that it was engaging in illegal conduct.
The trial court's analysis was found to be right, and she cited the undisputed evidence that Specialty already had investigated this legal issue before Tuli’s letter.
She likewise noted Tuli offered no evidence that additional investigation would have changed anything. The trial court distinguished this situation from a whistleblower situation “where a shareholder would alert members of a corporation or LLC to actual illegal activity, or that the Board was attempting to take action without any investigation at all into its legality.”
Tuli complained about the trial court’s rejection of his unfair competition claim which was that Specialty engaged in unfair competition by labeling his letter a terminating event, declaring he had disrupted the company, and stripping him of his ownership share without compensation.
The trial court reasoned the business judgment rule protected Specialty’s rational action of preventing existing shareholders from telling prospective investors that new investment might be a crime.
The trial court was right because the business judgment rule indeed applied, and no exception annulled its operation. Tuli’s appellate argument cited no logic or authority to unhorse this result.
Tuli attacked the trial court’s ruling on his fiduciary duty claim which was that Specialty and its members breached their duties to Tuli by casting him out without payment. The trial court applied the business judgment rule and deferred to Specialty’s rational purpose of ejecting a company saboteur.
On appeal, Tuli argued Specialty’s purpose was to fund a special distribution for existing members rather than to aggregate new business capital.
This argument was unavailing, because both business purposes are rational. Company owners rationally want business returns as well as operating capital.
Tuli also argued Specialty did not follow proper company procedures because the board did not meet and vote before Specialty notified him of the terminating event.
The trial court ruled this procedural irregularity was substantively irrelevant, because board members all agreed with Specialty’s action. The court also noted Tuli cited no cases saying that technical violations of corporate procedure created an exception to the business judgment rule.
After trial, the court made factual findings, including that all versions of Specialty’s operating agreement from 2005 on contained the terminating event provision.
Brooks and Tuli discussed this provision with potential physician members. Tuli endorsed it in numerous conversations as a way to ensure “bad actors” would not damage Specialty.
Tuli understood “that with that formula, with the company that was distributing all of its profits, nobody was going to get anything when they committed a terminating event and their shares were redeemed.”
LESSONS:
1. The business judgment rule is a presumption that the directors of a corporation make business decisions on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company. Courts defer to board judgments that can be attributed to any rational business purpose.
2. The rule applies to limited liability companies as well as to corporations.
3. The business judgment rule insulated Specialty and its decisionmakers from Tuli’s claim they breached their fiduciary duty to him.
4. Specialty established this affirmative defense by proving its business purpose was rational: Specialty sought to continue to use private offerings to raise capital without baseless allegations of illegality and impropriety from an existing shareholder.
5. The objective of a corporation is to enhance the economic value of the corporation.