Although a Low Threshold, the Business Judgment Rule Does Not Always Protect a Director

Where the directors knew the officers’ high salaries were “outrageous” and well in excess of comparables within the market but nonetheless failed to reduce the salaries, a jury question existed whether the directors engaged in a “rational” process such that the Business Judgment Rule (“BJR”) would protect the directors.  Lee v. McDowell, et al, 2022 NCBC 28 (J. Bledsoe).  As a result, the Business Court denied the directors’ motions for summary judgment on the breach of fiduciary duty claims related to the officers’ salaries.

Plaintiffs were investors in a company known as rFactr, Inc. (“Company”), which used sales technology to help businesses more effectively use social media to increase sales. Defendant McDowell was an investor and eventually became a board member.  Defendant Dunn was also a board member during McDowell’s tenure on the Board.  During their multi-year tenancy on the Board, both Dunn and McDowell continuously challenged the direction the officers were taking the Company but, because the officers were also directors, McDowell and Dunn did not have the votes to change the course of the Company.  McDowell and Dunn did, however, control compensation decisions for the officers, Brasser and Gentner. McDowell and Dunn repeatedly expressed their “horror” over Brasser and Gentner’s “outrageous” salaries, which beliefs were confirmed when an outside consultant advised the officers were being paid at least three times the going rate.  But McDowell and Dunn did not reduce the officers’ salaries, believing that the loss of the officers would be a greater detriment to the Company than the excessive salaries being paid. Eventually, the Company suffered significant financial failure and ceased all operations.  Plaintiffs sued McDowell and Dunn (along with a later director) alleging, inter alia, breach of fiduciary duty in relation to the officers’ salaries.  After discovery, Dunn and McDowell moved for summary judgment, contending their decisions relating to the officers’ salaries were protected by the BJR as a matter of law.

The Business Court disagreed.  Although the BJR requires only a “minimal burden” in order to be satisfied (Opinion, ¶47), the Business Court nonetheless recognized that the directors must prove they engaged in a “rational process” in addressing the officers’ compensation.  (Id., ¶62).  Given that the directors knew the officers’ compensation was widely excessive, believed the officers might be acting with willful malfeasance, and had the authority to reduce the compensation but still failed to do so, the Business Court determined that a jury needed to decide whether the directors had acted rationally or, instead, had unreasonably permitted the waste of the Company’s assets.  (Id., ¶61-62).

Additional Legal Points:

  • Board decisions that approve compensation amounting to corporate waste are not protected by the BJR. (Opinion, ¶58).
  • North Carolina courts will often look to Delaware court decisions for guidance concerning a director’s duties related to overseeing the company’s business operations. (Id., ¶43).
  • The Delaware Chancery Court’s decision in In re Caremark Int’l Inc. Derivative Litigation, created a “minimal burden” that a director need show in order to satisfy the BJR. (Id., ¶44,47)
  • In order to maintain a claim for breach of the duty of loyalty, a plaintiff must show that the breach actually caused injury to the company, otherwise it cannot be maintained. (Id., ¶68).

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