Gaillard v. Natomas Co.
1989 Cal. App. LEXIS 246, 208 Cal.App.3d 1250, 256 Cal. Rptr. 702 (1989)
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Rule of Law:
The business judgment rule does not protect self-interested inside directors who receive 'golden parachute' benefits in a merger. While the rule may protect disinterested outside directors who approve such benefits, their protection is not absolute and is subject to judicial review for whether they exercised due care, including a reasonable inquiry into the purpose and fairness of the agreements.
Facts:
- In May 1983, Diamond Shamrock Corporation initiated a hostile tender offer to acquire Natomas Company.
- During subsequent friendly merger negotiations, Natomas's CEO, Dorman L. Commons, proposed amending the employment agreements for himself and four other senior executives to include lucrative 'golden parachute' severance provisions.
- The proposed agreements allowed the executives to terminate their employment for 'Good Reason' within six months of the merger, or for any reason thereafter, and receive lump-sum payments totaling approximately $10 million.
- A compensation committee of five outside Natomas directors, relying heavily on the advice of outside counsel Joseph Flom, met for less than two hours and recommended that the full board approve the agreements.
- The full board of outside directors then approved the agreements, with the five interested inside directors abstaining from the vote.
- Shortly after the merger was consummated on August 31, 1983, all four executives with golden parachutes voluntarily terminated their employment with Natomas and received their severance payments.
- A fifth executive, W. B. Seaton, was given a four-year consulting agreement for $250,000 annually but provided minimal services during that period.
Procedural Posture:
- Shareholders Tilly Gaillard and Vincent J. Ashton filed separate derivative actions against the directors of Natomas Company in a California trial court.
- The defendant directors moved for summary judgment, arguing their actions were protected by the business judgment rule.
- The trial court granted summary judgment in favor of all director defendants and dismissed the shareholders' actions.
- The plaintiff shareholders appealed the trial court's grant of summary judgment to the California Court of Appeal.
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Issue:
Does the business judgment rule, as codified in California Corporations Code § 309, protect inside and outside directors from liability for approving 'golden parachute' employment agreements for the inside directors during merger negotiations?
Opinions:
Majority - Strankman, J.
No, the business judgment rule does not automatically protect the directors from liability under these circumstances. The rule does not apply to the inside directors who were beneficiaries of the agreements, and triable issues of fact exist as to whether the outside directors exercised the requisite level of care and inquiry to be protected by the rule. The inside directors were not performing their duties as directors when they secured benefits for themselves; they were acting as officers in a self-interested transaction, which falls outside the scope of the business judgment rule's protection for disinterested decisions. For the outside directors, while the business judgment rule generally applies, their reliance on a committee and legal counsel is not absolute. The court found that several 'red flags'—including the suspicious timing of the parachutes (after merger terms were set), their terms encouraging departure rather than retention, and the large payments—created a triable issue of fact as to whether the outside directors' failure to conduct a more thorough inquiry violated their duty of care under § 309.
Analysis:
This case significantly clarifies the application and limitations of the business judgment rule in California concerning executive compensation, particularly in the M&A context. It establishes a clear distinction between self-interested inside directors, who receive no protection from the rule for such transactions, and disinterested outside directors, whose protection is conditioned on active and reasonable inquiry. The decision serves as a warning to boards that they cannot passively 'rubber-stamp' lucrative severance packages, even on the advice of prestigious counsel, especially when circumstances suggest potential self-dealing or corporate waste. It reinforces the principle that director reliance on committees or experts must be reasonable and does not absolve them of their fundamental duty of care to scrutinize major corporate decisions.
