In Scheenstra v. California Dairies, Inc., No. F062768, ___ Cal. Rptr. 3d ___, 2013 WL 363148 (Cal. App. 5th Dist. Jan. 30, 2013), the California Court of Appeal, Fifth District, affirmed the judgment of the California Superior Court, Tulare County, that the board of directors of defendant California Dairies, Inc. (“Cal Dairies”), a milk marketing and processing cooperative, had exceeded its discretion when it adopted a quota system that breached its contractual obligations to its members and exceed the grant of power in Cal Dairies’ Bylaws. This decision highlights that a board of director’s discretion under the business judgment rule may be limited by contractual obligations the corporation undertakes with the corporation’s shareholders/members.

Cal Dairies markets its members’ milk to the best advantage of its members. Upon joining Cal Diaries, a member agrees to be bound by the cooperative’s Bylaws as they exist and as they may be amended. The Bylaws thus constitute a contract between Cal Diaries and each of its members.

One such member was plaintiff John Scheenstra. Between 2002 and 2007, plaintiff began expanding his milk production capacity. In the fall of 2007, the board of directors of Cal Dairies began considering the need to reduce the milk production of its members due to anticipated overproduction. The board decided to exercise the discretionary authority granted in section 7.3 of Cal Dairies’ Bylaws to institute an internal production quota. Section 7.3 of the Bylaws obligates Cal Dairies to accept all of the milk of its members “subject to the right of the Board, in its discretion, upon written notice to the membership . . . to allocate equitably among the members on a uniform basis . . . the quantity . . . of milk to be received by the Association.” Cal Dairies adopted a system that set a production quota based upon average daily production numbers for 2007. At the time the board adopted the supply management program, it knew (1) there were member dairies with declining production and allocating a base using an annual average would provide those dairies with a base in excess of their actual production and such excess base would be a saleable asset; (2) there were a number of member dairies, including plaintiff’s, with increasing production; and (3) the base allocation would not account properly for dairies with increasing production.

After attempting (and failing) to obtain relief directly from the board by showing that the quota system was causing him extreme hardship, plaintiff filed a lawsuit for breach of a written contract, breach of the covenant of good faith and fair dealing, and negligent misrepresentation.

After a bench trial, the trial court dismissed each of plaintiff’s claims except for the claim for breach of contract. The trial court analyzed the terms of the Bylaws and concluded that Cal Dairies breached its contractual obligation to implement a supply management program equitably, uniformly and based upon representative years of production. With respect to damages, the trial court determined that the correct measure of damages was the difference between the amount plaintiff received under the improper formula, and the amount he would have received under a proper uniform, equitable plan.

Cal Dairies appealed, arguing that the trial court erred by failing to apply the business judgment rule and give deference to its board of directors’ choice of terms for the production quota system. The Court of Appeal rejected Cal Dairies’ argument. As a preliminary matter, it held that Cal Dairies, as a nonprofit cooperative association, was a membership corporation without capital stock. Accordingly, any deference given to its board of directors would be derived from the business judgment rule. (Even if Cal Dairies had been an unincorporated association, it still would have benefited from an analogous “judicial deference” rule. Like the business judgment rule, the “judicial deference” rule insulates from court interference management decisions made by directors loyally, with due care and in their good faith belief that the decisions are in the organization’s best interests.)

The application of the business judgment rule to the facts of this case, however, was not straightforward. The board decision at issue — establishing the terms of the production quota system — was subject to the terms of the contract between plaintiff and Cal Dairies. Thus, the board’s decision implicated both its management responsibilities and Cal Dairies’ contractual obligation to perform as agreed with plaintiff and the other member dairies. Here, the contract granted discretion to the Cal Dairies board on a matter involving business operations, but also limited that discretion by requiring the board to allocate milk quantities equitably among members on a uniform basis. In a situation where a contract grants a board limited discretion, the Court concluded, the board’s decision will not be afforded deference under the business judgment rule until after the court properly determines that the action of the board falls with the discretionary range of action authorized by the contract. Here, the Court of Appeal affirmed the judgment on the breach of contract claim in favor of plaintiff.

Scheenstra stands for the proposition that the business judgment rule will not protect board decisions in contravention of specific contractual obligations. To benefit from the deference granted by the business judgment rule, a board of directors must act within its authority and pursuant to its obligations to its shareholders/members.