Self-Dealing By Director Is A Breach Of Fiduciary Duty (Case 1)

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Facts

Plaintiff, Coley, owns a home in an HOA, the Eskaton Village (“Association”).  Two other Eskaton named entities (“Eskaton”) develop and support HOAs.  A five-member board runs the Association, subject to the Declaration.  Eskaton has always controlled three of the five directors on the Association Board because it owns 137 of the 267 units.  The three directors are always employees of Eskaton and are “financially incentivized to run the Association for the benefit of Eskaton.”  In short, the better Eskaton performs the higher their compensation, which is directly related to the expenses of the Association.  Coley, one of the other two directors, filed suit because of various acts by the other directors to benefit their employer at the expense of the Association, including disclosing attorney client privileged communications.

Issue

Whether “a conflict of interest was created when Eskaton retained control of the Association Board of Directors by filling three positions with its own employees.”

Trial Court

The trial court concluded this was a conflict of interest.  The court found the pay structure of the Eskaton employee directors was “an irreconcilable conflict of interest.”  If further found that the Eskaton directors “breached their fiduciary duties” with respect to three specific acts, including the disclosure of “Association’s privileged communications with its counsel.”  Coley also sought attorney fees of $1,140,445.03.  The court awarded Coley attorney fees in the amount of $648,058.25.  Both parties appealed.

Appeals Court

Eskaton argued that the business judgment rule applied and protected the directors.  The court held that a director “cannot obtain the benefit of the business judgment rule when acting under a material conflict of interest.”  The basic premise of the business judgment rule is undermined “when directors approve corporate transactions in which they have a material personal interest… [and when the majority of directors have such a conflict] the directors carrying this conflict of interest are precluded from seeking the benefit of the business judgment rule.”  However, regardless of the business judgment rule, a director can still defend his or her actions by proving the arrangement was “fair and reasonable” to the Association.  The court also held that the same result would be reached under Delaware law, which Eskaton argued applied, because Delaware case law would require the directors to “demonstrate both their utmost good faith and the most scrupulous inherent fairness of transactions in which they possess a financial business or other personal interest…”  The court then overturned the trial court and held each of the directors personally liable.  In the end, the court affirmed most of the trial court decision, but remanded the case for the trial court to reconsider the damages and attorney fees in light of its decisions and decide if the individual directors should be liable for some of the attorney fees.

LESSONS LEARNED
  1. Breach of fiduciary duty cases are very expensive;
  2. If you have a conflict of interest, do not participate in the decision or discussion, and excuse yourself from the room when the matter is before the Board;
  3. If you have a financial incentive to help another party (in this case the developer entities) then you may have an ‘irreconcilable conflict of interest” and you should strongly consider not accepting being a director or immediately resigning from that position.

Coley v. Eskaton, ___ Cal.Rptr.3d___, 20 Cal. Daily Op Serv. 6832, (2020)

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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