Veto Right Made All Directors Liable for Bad Decisions by a Few Directors

In a closely held corporation, it makes sense to give each owner a veto over important business decisions.

However, there is a downside, as shown in a July 22 opinion from the Eleventh Circuit: At least when the debtor is a bank in Georgia, directors who didn’t participate in approving a sour loan can be tagged for the negligence of other directors who made the decision.

The Right to Veto

Seven investors formed a bank, which they grew aggressively by making risky loans. Many of the loans were inexpertly underwritten, leading to the bank’s failure and a receivership by the Federal Deposit Insurance Corp.

As Circuit Judge Gerald B. Tjoflat explained in his opinion for the appeals court, the investors all sat on the board of directors. All loans above a specified amount required board approval.

At the weekly meetings to approve loans, a quorum was three directors. All directors, whether they attended the meetings or not, were given packets with pertinent information about the loans. Any one director could veto a loan, whether the director attended the meeting or not.

In view of the right to veto, Judge Tjoflat said in his chatty opinion that the decisions to approve loans were “group” decisions requiring the implicit or explicit approval of all board members. In other words, board members approved loans whether they voted at the meetings or not.

The FDIC sued the directors for negligence and gross negligence in approving 10 loans. For example, the appraisal for one loan was based on zoning that was never approved for the property.

According to Judge Tjoflat, the case was “infected with a conflict of interest” because the directors were all represented by the same lawyer. Although he said the directors should have been pointing the finger at one another, they introduced no evidence to show how much responsibility each had for approving the loans at issue.

The jury found the directors negligent and held them jointly and severally liable for $5 million because they failed to exercise “the same diligence and care as directors of a similarly situated bank would be expected to exercise,” Judge Tjoflat said.

To no avail, the directors appealed to the Eleventh Circuit, arguing primarily that Georgia’s apportionment statute precluded joint and several liability. The directors contended that the district judge erred in not instructing the jurors to fix the percentage of each director’s liability for each loan.

Apportionment

Judge Tjoflat’s 29-page opinion is largely about the tension between Georgia’s apportionment statute and the common law principle imposing joint and several liability on tortfeasors who act in concert. The opinion also shows how the business judgment rule is not a complete defense, at least not for directors of a Georgia bank.

The Georgia apportionment statute requires the trier of fact to “apportion its award of damages among the persons who are liable according to the percentage of fault of each person.” Because state law construing the statute was unsettled, the Eleventh Circuit certified several questions to the Georgia Supreme Court.

Summarized by Judge Tjoflat, the state’s high court made four pronouncements pertinent to the appeal: (1) Apportionment is the “default rule” for tort liability of bank directors; (2) apportionment “doesn’t apply to situations where it is impossible to divide fault among the liable defendants;” (3) it is “impossible to divide fault when the defendants acted in concert,” and (4) dividing fault may also be impossible “based on the legal theories or factual circumstances.”

In sum and substance, the veto right meant that the directors were acting in concert on every loan. The evidence, Judge Tjoflat said, “showed that it’s impossible to divide fault among the liable directors” because the decision to approve each loan “was a group decision.” By voting “yes,” he said, “the quorum of three effectively spoke for the absent members.”

Judge Tjoflat summarized the Georgia Supreme Court’s description of how and when the common law rule of concerted action survived the adoption of the apportionment statute. The state high court said that common law governs when there is a “tacit understanding” to act in concert. Derived from the law of agency, concerted action imputes fault to those who acted together.

In simple terms, the veto right meant that all directors acted together, whether they voted or not, with the result that the common law of concerted action overcame the apportionment statute.

Finally, Judge Tjoflat dealt with the business judgment rule, a seemingly watertight defense to a bad business decision. In Georgia, he said that the rule protects directors only in the “wisdom” of their decision. He said that the rule “does not protect directors from negligence claims that challenge the way a decision was made because the decision-making process ‘did not comport with the duty to exercise good faith and ordinary care.’” [Emphasis in original.]

By finding that the directors did not exercise the required degree of diligence, the business judgment rule did not apply — in Georgia, that is.

The takeaway: Think twice before giving everyone a right of veto.

Question: If the apportionment statute were federal statutory law, not state law, would the U.S. Supreme Court allow federal common law to prevail? The Court may give us a hint by its ruling this coming term in Rodriguez v. Federal Deposit Insurance Corp., 18-1269 (Sup. Ct.). For an ABI report on Rodriguez, click here.