In a move that may hold important implications for not-for-profit governance, a U.S. District Court judge in Los Angeles threw out a portion of a lawsuit seeking to hold the former board of directors of bankrupt Granada Hills (Calif.) Community Hospital financially responsible for the hospital's failure in 2003.
In a summary judgment issued last week, Judge George Schiavelli ruled that the six former directors were shielded from personal liability under state law. At the same time, Schiavelli allowed the case to stand against Granada Hills' former officers and the turnaround firm that led the hospital's botched reorganization.
The decision should provide some comfort and clarity to directors of not-for-profit hospitals in the wake of the Sarbanes-Oxley Act of 2002, said Cary Miller, lead defense counsel for Granada Hills' directors. Although aimed at boosting accountability among publicly traded companies, the passage of Sarbanes-Oxley has left many of those in not-for-profit governance equally concerned about their exposure to corporate liability.
"The ruling is a reassurance to directors, particularly of nonprofits, that they do have very strong protections that allow them to govern their hospitals without fear of the courts second-guessing them," said Miller, a partner with the law firm Hooper, Lundy & Bookman.
Granada Hills' financial troubles stem back to 1998, when it began struggling with reduced payment rates and increased competition. The 139-bed, not-for-profit hospital filed for Chapter 11 bankruptcy protection in November 2002 after the collapse of its accounts-receivable financier, National Century Financial Enterprises. By then, it had amassed $18 million in debt and was on track to lose $7 million that year.
Soon afterward, the hospital hired Healthcare Resource Specialists, a newly formed turnaround company based in Tampa, Fla., to lead its reorganization. Healthcare Resource appointed James Doulgeris and Mark Jonas, as the hospital's interim chief executive officer and chief financial officer, respectively. At the time, Doulgeris was a principal of Healthcare Resource, and Jonas was CFO of Healthcare Resource's parent, Bay Management Group.
After amassing another $6 million in debt, Granada Hills converted its case to Chapter 7 liquidation in July 2003. The hospital shut down, and in March 2004, the 11-acre property was sold for $22.5 million to the Los Angeles Unified School District for use as a high school.
The lawsuit, filed by bankruptcy trustee David Gottlieb in June 2004, claimed that Granada Hills' directors breached their fiduciary duty by hiring Healthcare Resource without "a modicum" of due diligence and by failing to provide adequate oversight of the fledgling firm's activities. According to the lawsuit, the turnaround firm continued to deplete the hospital's assets while concealing its deteriorating condition from the board. "The effect of the officers' nondisclosure and the board's failure to supervise and make reasonable inquiries about the hospital's operations and finances was to drive the hospital deeper into insolvency," the lawsuit said.
Attorneys for the directors, however, successfully argued that Granada Hills' board was protected under California's "business judgment rule," which shields directors of not-for-profit organizations from personal liability as long as they perform their duties "in good faith ... in the best interests of the corporation, and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use."
Virtually all states and the federal government have similar immunity statutes on their books. As a result, few lawsuits have been filed against not-for-profit directors and, so far, none have prevailed at trial. "This ruling reflects the majority law in all 50 states," said lawyer Edward Bryant, a principal of Gardner, Carton & Douglas.
Still, Bryant warns directors not to get too complacent. It's only a matter of time, he said, before a court or legislature limits how far the "in good faith" defense will stretch. "Eventually, someone is going to do something so dumb that it tips the scales from negligence to bad faith," said Bryant, a faculty member of the Governance Institute.
Louis Kempinsky, an attorney representing Gottlieb, said his client is already considering an appeal.
Meanwhile, the trial is scheduled to begin Dec. 5 in the case against Doulgeris, Jonas and Michael Sussman, Granada Hills' former chief operating officer. Doulgeris and Jonas are also accused of acting in their own self-interest by paying Healthcare Resource $1.2 million in management fees while failing to pay $1 million in payroll taxes and $5 million in bills from local vendors. The lawsuit seeks $10 million in damages.