What is the Business Judgment Rule in California?

In the recent case of Tuli v. Specialty Surgical Center of Thousand Oaks, LLC, the California appellate court reviewed the business judgment rule.

Randhir Tuli is not a medical doctor, but he helped form a medical business. For a time, Tuli contributed to the enterprise, but then he lapsed into inactivity: he did nothing productive. He did, however, keep taking millions from the enterprise’s profits. 

 

His hardworking surgeon colleagues in this business became restive and sought to buy him out, but Tuli refused to surrender his lucrative perch. 

 

Then Tuli directed his lawyer to send an aggressive—and fateful—letter to a wide swath of recipients, including potential investors in the surgical business. The letter was professionally designed to be scary. It suggested the specter of criminal liability for all involved. Tuli had no good faith belief in the factual or legal basis for his specious claim. 

 

In response to his baseless and damaging letter, others in the limited liability company warned Tuli they would eject him without compensation, as was their right, unless he cured the situation within 30 days. Tuli spurned their offer. 

 

The surgeons made good on their ultimatum: they put Tuli out and paid him nothing. 

 

Tuli launched a decade-long litigation campaign against his former business colleagues. The trial court rejected all Tuli’s claims and the appellate court affirmed. 

From 1997 to 2005, Tuli and defendant Dr. Andrew Brooks worked together to create a group of surgery centers. Tuli was an experienced and sophisticated entrepreneur whose ventures had won him millions of dollars. 

 

These centers created lower cost alternatives to hospitals: they eliminated a costly intermediary between surgeon and patient. 

 

The corporate form of ownership for each center was a limited liability company. Specialty was a limited liability company. An operating agreement governed its activities. 

 

In 2005, a Tennessee entity we will call Symbion paid Brooks and Tuli over $16 million each to buy their interests in every center except the Specialty location. 

 

Tuli, Brooks, and Symbion set up Specialty to be a pass- through entity. Specialty did not accumulate retained earnings. 

 

Every month, it distributed to members all the revenue it collected from recent surgeries. The idea was to convince the member surgeons that this was an attractive and immediately profitable place for them to conduct surgeries. 

 

Specialty’s only real asset was its members’ entitlements to get a share of the revenues from future surgeries. Its one asset was prospective only. 

 

There was no publicly traded market in Specialty’s shares. Tuli and Brooks had designed Specialty to be a closed and selective organization; they wanted complete control over the surgeon investors they would solicit and would accept for membership in their elite and highly profitable firm. It took a lot more than just money to become a Specialty member. 

 

A central feature of each version of Specialty’s operating agreement was the provision about a “terminating event.” The terminating event provision was designed to ensure “bad actors” within the company did not damage it. The founders sought to prevent an insider from destroying the business. 

 

They “spent a lot of time negotiating” the terminating event provision. They discussed it in detail with each other and with potential physician members. 

 

A “terminating event” would occur when a Member has disrupted the affairs of the Company or has acted adversely to the best interests of the Company, as determined in the reasonable discretion of the Governing Board, and fails to cure such conduct within thirty (30) days after receipt of a written notice of such conduct sent by the Governing Board to such Member.

 

The pertinent consequence of a terminating event was loss of the offending member’s Specialty shares. 

 

Friction arose at Specialty when Tuli wandered off the job—permanently. By the end of 2007, Tuli had completely abandoned Specialty. 

 

Tuli’s inactivity at Specialty caused consternation to its doctor members. Their work generated all of the revenue. By contrast, Tuli’s productive effort was zero, but he continued to get 11.3% of the take. 

 

At the time of the dispute, for instance, Specialty was distributing over a million dollars a year to Tuli for nothing in return. 

 

In 2010 and 2011, Goodwin, on behalf of the physicians at Specialty, offered to buy Tuli’s interest. Tuli refused, claiming their offer was an “unfair lowball price.” He wanted more money. 

 

On February 13, 2014, Tuli took his fateful action. He directed his attorney to send a threatening letter. Tuli’s decision prompted Specialty to oust him from the company. 

 

The cover note warned that “[f]ailure to do so may expose you to individual liability.” 

 

Tuli’s saber rattling backfired. Specialty ejected him from the company without compensation. Tuli responded with this lawsuit, which is now more than ten years old. 

 

Specialty ousted Tuli in March 2014. It redeemed Tuli’s ownership shares for zero dollars and ended his participation in the company. 

 

The fundamental principle governing this case is the business judgment rule.

This rule is a presumption that the directors of a corporation make business decisions on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company. Courts defer to board judgments that can be attributed to any rational business purpose.

 

The parties did not dispute that this rule applies to limited liability companies as well as to corporations. 

 

The trial court ruled the business judgment rule insulated Specialty and its decisionmakers from Tuli’s claim they breached their fiduciary duty to him. 

 

The court found Specialty established this affirmative defense by proving its business purpose was rational: Specialty sought to continue to use private offerings to raise capital without baseless allegations of illegality and impropriety from an existing shareholder. 

 

The evidence supported Specialty’s rational fear that Tuli’s letter would scare off potential investors, that it was rational to notify Tuli his letter was a terminating event, and that it was rational to oust him when he refused to cure within 30 days of Specialty’s notice. 

 

Tuli contended the business judgment rule should not apply to his case for three reasons: conflict of interest, bad faith, and improper investigation. 

 

Tuli claimed a conflict of interest infected the governing board’s decision making, which Tuli maintained made it error to apply the business judgment rule to this case. 

 

The conflict-of-interest exception to the business judgment rule arises when the interests of the individual decisionmakers diverge from the interest of the enterprise as a whole. 

 

A classic example is when directors, faced with a merger, adopt defensive measures but might be acting to protect their own interests rather than those of the corporation and shareholders.

 

This situation sparks the fear the individual decisionmakers are not to be trusted, for they might be serving their self-interest at the expense of the interests of the entity and its owners, like the shareholders. When the decisionmakers’ personal interests conflict with the enterprise’s interests, the business judgment rule does not apply. 

 

The uncontested evidence in this case, however, was that Specialty’s decisionmakers worked in the best interest of the company as a whole.

 

Tuli also argued the business judgment rule did not apply because bad faith and improper motives drove the governing board to be rid of him. 

 

“Bad faith” is a common law term in corporate law with an indefinite meaning. 

 

“The black letter requires that officers and directors act in good faith to receive the protection of the business judgment rule. The term ‘bad faith’ is used extensively in corporate law, and the extent to which its meaning varies depending on the context in which it is used is unclear. . . . Illegal conduct may constitute bad faith, and courts have generally stated that the business judgment rule does not apply to knowingly illegal conduct.” 

 

Tuli argued Goodwin, Brooks, and “the other Defendants” exhibited “extreme animosity against Tuli.” “They had been ‘extremely upset’ with Tuli for a long time, were frustrated that he was earning high profits without bringing in business or providing services, and had repeatedly and unsuccessfully tried to buy his units.” 

 

It is not bad faith to offer to buy out an unproductive element, as Tuli conceded. He admitted there was nothing wrong with offering to buy his shares. 

 

Nor is it corporate bad faith for company decisionmakers to be frustrated with a corporate team member who is earning “high profits,” as Tuli phrased it, for doing nothing. 

 

The appellate court saw no logic in adopting this position, which is at odds with the notion that corporate decisionmakers should be working to maximize enterprise value for the benefit of corporate owners. 

 

The objective of a corporation is to enhance the economic value of the corporation. 

 

In any organization, emotions sometimes can run high. After one business person attacks another before an audience of associates, without a good faith basis, it would be not unusual for the victim to scorn the attacker. 

 

Tuli supplied no precedent for extending the concept of bad faith to a situation where a company decisionmaker, while working in the company’s best interests, privately disparaged a colleague. 

 

Tuli made a third argument as to why the business judgment rule does not apply: Specialty, he claims, did not properly investigate the charge in his letter that it was engaging in illegal conduct. 

 

The trial court's analysis was found to be right, and she cited the undisputed evidence that Specialty already had investigated this legal issue before Tuli’s letter. 

 

She likewise noted Tuli offered no evidence that additional investigation would have changed anything. The trial court distinguished this situation from a whistleblower situation “where a shareholder would alert members of a corporation or LLC to actual illegal activity, or that the Board was attempting to take action without any investigation at all into its legality.” 

 

Tuli complained about the trial court’s rejection of his unfair competition claim which was that Specialty engaged in unfair competition by labeling his letter a terminating event, declaring he had disrupted the company, and stripping him of his ownership share without compensation. 

 

The trial court reasoned the business judgment rule protected Specialty’s rational action of preventing existing shareholders from telling prospective investors that new investment might be a crime. 

 

The trial court was right because the business judgment rule indeed applied, and no exception annulled its operation. Tuli’s appellate argument cited no logic or authority to unhorse this result. 

 

Tuli attacked the trial court’s ruling on his fiduciary duty claim which was that Specialty and its members breached their duties to Tuli by casting him out without payment. The trial court applied the business judgment rule and deferred to Specialty’s rational purpose of ejecting a company saboteur. 

 

On appeal, Tuli argued Specialty’s purpose was to fund a special distribution for existing members rather than to aggregate new business capital. 

 

This argument was unavailing, because both business purposes are rational. Company owners rationally want business returns as well as operating capital. 

 

Tuli also argued Specialty did not follow proper company procedures because the board did not meet and vote before Specialty notified him of the terminating event. 

 

The trial court ruled this procedural irregularity was substantively irrelevant, because board members all agreed with Specialty’s action. The court also noted Tuli cited no cases saying that technical violations of corporate procedure created an exception to the business judgment rule. 

 

After trial, the court made factual findings, including that all versions of Specialty’s operating agreement from 2005 on contained the terminating event provision. 

 

Brooks and Tuli discussed this provision with potential physician members. Tuli endorsed it in numerous conversations as a way to ensure “bad actors” would not damage Specialty. 

 

Tuli understood “that with that formula, with the company that was distributing all of its profits, nobody was going to get anything when they committed a terminating event and their shares were redeemed.” 

 

LESSONS:

 

1.         The business judgment rule is a presumption that the directors of a corporation make business decisions on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company. Courts defer to board judgments that can be attributed to any rational business purpose. 

 

2.         The rule applies to limited liability companies as well as to corporations. 

 

3.         The business judgment rule insulated Specialty and its decisionmakers from Tuli’s claim they breached their fiduciary duty to him. 

 

4.         Specialty established this affirmative defense by proving its business purpose was rational: Specialty sought to continue to use private offerings to raise capital without baseless allegations of illegality and impropriety from an existing shareholder. 

 

5.         The objective of a corporation is to enhance the economic value of the corporation. 

What Issues Concern Easements Between Adjoining Properties in California?

In the recent California decision of Batta v. Hunt, the judgment of the Superior Court was reversed in the case that involved a dispute over two adjacent parcels of property each containing a multi-unit apartment complex with on-site parking for their residents. 

The parties sought to determine their rights regarding a purported easement to use a disputed area on one parcel for additional space for tenant parking and trash dumpsters. 

 

After a bench trial, the trial court entered a judgment in favor of plaintiffs, appellants, and cross-respondents Eli and Maha Batta (the Battas), finding they had established easement rights for additional parking and the dumpsters in the disputed area on the adjacent parcel, which was owned by defendant, respondent, and cross-appellant Therese Hunt. 

 

The trial court found the Battas established their easement rights under multiple theories, including by oral grant, by prescription, and by implication. 

 

While the trial court granted the parking and trash dumpster easement in favor of the Battas, it ordered that the easement would expire upon a bona fide sale of either property by the Battas or Hunt. 

 

Both parties appealed, and Hunt argued the trial court erred in granting the easement rights on various procedural and evidentiary grounds.

 

The Battas argued the trial court abused its discretion in ruling the easement would expire upon a bona fide sale of either property. 

 

The appellate court reversed the judgment and remanded the case for further proceedings. 

Hunt owned two adjacent properties located at 6870 Woodley Avenue (the Hunt Property) and 6866 Woodley Avenue (the Batta Property). The Hunt Property contains a four-unit apartment building and a separate carport to the west of the building. 

 

The Batta Property sits directly south of the Hunt Property and contains a nine-unit apartment building, which includes an overhang in the back of the building where tenants can park. The Batta Property also contains two additional parking spaces in the front of the building. A driveway runs east to west between the two apartment buildings. 

 

The Battas purchased the Batta Property from Hunt in 1994. 

 

In 2019, the Battas sought a parking covenant from Hunt to prove to the City of Los Angeles that the Batta Property had sufficient available parking spaces. 

 

When Hunt refused to sign the covenant, the Battas brought this action, seeking an easement for parking as well as space to place their dumpsters, which had also been placed on the Hunt Property since the time of purchase. 

 

The Battas’ original complaint alleged causes of action for (1) quiet title to an easement by grant, (2) quiet title to an easement by prescription, (3) quiet title to an irrevocable license, and (4) breach of contract. 

 

They sought a determination as to whether the Batta Property tenants could use four parking spaces on the Hunt Property and whether the Battas could place a garbage dumpster on the Hunt Property adjacent to the four parking spaces. 

 

The Battas alleged their tenants had parked in the same locations on the Hunt Property since their purchase in 1994, and the dumpster had always been placed in the same location. The Battas alleged the disputed area was subject to an easement granted by Hunt.

 

The Battas further alleged a description of the easement was contained in a real estate transfer disclosure statement (TDS) completed by Hunt after the Battas purchased the Batta Property. 

 

The Battas alleged they would not have purchased the property without an easement. 

 

After issuing a series of tentative and final statements of decision, the trial court ruled in favor of the Battas. 

 

The trial court found clear and convincing evidence that before the Battas purchased the Batta Property, Hunt owned the two adjacent parcels. There was a four-unit apartment building on the Hunt Property and a nine-unit on the Battas Property.

When Hunt owned both properties, she subdivided one of the units in the Batta Property, adding a nonpermitted ninth unit. 

 

Between 1977 and 1994, while Hunt owned both properties, the tenants for the Batta Property parked their cars in three parking spaces behind the carport of the Hunt Property, and the Batta Property’s trash and recycling dumpsters were stored near the back of the Hunt Property’s carport. 

 

The Battas purchased the Batta Property from Hunt in 1994. Before the Battas purchased the property, all of the tenants in both apartment buildings parked wherever it was most convenient for them. After the Battas purchased the property, their tenants continued to park on both the Hunt Property and the Batta Property. 

 

Before selling the Batta Property, Hunt told the Battas she believed there was an easement on the Hunt Property, which gave the Batta Property rights to park and place a trash dumpster on the Hunt Property. Although the purchase agreement did not mention an easement, Hunt described an easement in the TDS. 

 

The TDS identified an easement on the Hunt Property for parking for two units of the Batta Property and space for the dumpster. Hunt also verbally told the Battas there was an easement for parking and the dumpster. 

 

Both Hunt and the Battas expected that the tenants in two of the units on the Batta Property would continue to use the three parking spaces behind the Hunt Property carport pursuant to the easement, and the parties operated under this assumption from the time of purchase until 2019. 

 

After the sale, Hunt never told the Battas or their tenants that they could or could not continue to park on the Hunt Property. Hunt never really knew exactly where the property line was along the driveway between the two properties. 

 

The Battas paved the area behind the Hunt Property carport and also the driveway. Hunt knew about the paving but took no action to prevent it, remove it, or check the property line. The paved driveway covers areas on both proprieties; however, the vast majority sits on the Batta Property. 

 

The Batta Property tenants used the driveway between the two apartment buildings to access the parking. The driveway was partially on the Hunt Property. The tenants needed this driveway to access the parking spaces, three of which were on the Hunt Property while the remainder were on the Batta Property. 

 

While the Batta Property had some additional on-site parking, the spaces were not realistically usable as some appeared to be too narrow or difficult to access without damaging the cars or supporting beams. Further, some of these additional spaces on the Batta Property had been used for almost 30 years as a common area for the tenants. 

 

Both sides expected that after the Battas purchased the property, the dumpster would continue to be stored against the back wall of the Hunt Property carport, which is located at the end of the parties’ shared driveway. 

 

The parties never recorded an easement. Instead, the parties continued to operate as if there was an easement from the time the Battas bought the Batta property in 1994 until 2019. 

 

In support of its finding that the Battas had established an easement by prescription, the trial court found the Battas did not have permission to the use the disputed area on the Hunt Property. It found Hunt’s testimony that she gave the Battas permission to use the land was not credible.

The trial court entered judgment in favor of the Battas.

It found there was an easement by implication, by oral grant and by prescription in favor of the Batta Property for three parking spaces on the Hunt Property and space for a trash and recycling dumpsters. 

 

It further found a nonexclusive driveway easement by implication, oral grant, and by prescription between the Batta Property and the Hunt Property to the extent the driveway overlaps the two properties in order for the Battas’ tenants to access the parking spaces and dumpsters. 

 

The trial court enjoined the Hunt Property from using the easement in a manner inconsistent with its findings. The trial court further ordered that the easement did not run with the title of either property and that the easement would expire in the event of a good faith bona fide sale by the parties. 

 

The trial court also ordered a nonexclusive easement by implication, by oral grant, and by prescription to the extent that the driveway was necessary access to the Batta Property.

The trial court ordered this easement to run with title to both properties. 

 

An easement is an interest in the land of another, which entitles the owner of the easement to a limited use or enjoyment of the other’s land. 

 

An easement creates a nonpossessory right to enter and use land in another’s possession and obligates the possessor not to interfere with the uses authorized by the easement.

 

Relevant here, easements may be created by an express grant, an implied grant, or by prescription. 

 

An express grant of an easement may be created by an executed oral agreement. 

 

Courts will create an easement by executed oral agreement where a seller orally agrees that the buyer will have an easement over the seller’s property, but fails to convey it expressly by the deed and where the buyer uses and improves the easement and performs the contract.  

 

An implied easement will be found where the following conditions exist: (1) the owner of property conveys or transfers a portion of that property to another; (2) the owner’s prior existing use of the property was of a nature that the parties must have intended or believed that the use would continue; meaning that the existing use must either have been known to the grantor and the grantee, or have been so obviously and apparently permanent that the parties should have known of the use; and (3) the easement is reasonably necessary to the use and benefit of the quasi-dominant tenement. 

 

A prescriptive easement will be found where the party seeking the easement proves use of the property for the statutory period of five years and where the use has been (1) open and notorious; (2) continuous and uninterrupted; (3) hostile to the true owner; and (4) under claim of right. 

In other words, an easement acquired by prescription is one acquired by adverse use for a certain period. 

 

Adverse use’ means that the claimant’s use of the property was made without the explicit or implicit permission of the landowner. 

 

This requirement ensures that a prescriptive easement can arise only if the owner had an opportunity to protect his or her rights by taking legal action to prevent the wrongful use, yet failed to do so.

 

 

Here, the evidence the trial court relied on to rule in favor of the Battas on their claims for easements by implication and oral grant establish that the Battas’ use of the Hunt Property was not adverse. 

 

The trial court found that the Hunt’s statements to the Battas prior to the purchase and subsequently the TDS constituted an oral grant of an easement. It also found that the parties expected that the tenants would continue to park their cars on the Hunt Property as if there was an easement at the time of purchase. 

 

In other words, the trial court’s findings reflect that the Battas’ use of the Hunt Property was permissive. 

 

On the other hand, in finding that the Battas established a prescriptive easement over Hunt’s Property, it concluded that Hunt did not give permission for the Battas to use her property. 

 

In sum, the trial court found there was an express or implied agreement but no permission. 

These findings are inherently conflicting, irreconcilable, and, as explained in more detail below, require reversal of the judgment. 

 

The Battas seem to concede that the trial court made inconsistent findings. However, the Battas argue we should modify the judgment and affirm since it is apparent the trial court intended to grant easement rights over the Hunt Property and the Battas established those rights either by implication or oral grant. 

 

The appellate court decided modification and affirmance would be inappropriate here. 

 

Here, the Battas argue they sufficiently established their rights to an easement by implication and oral grant; therefore, we should affirm the judgment as modified because the judgment is correct on at least one of these theories. 

 

In examining these remaining theories, the appellate court found that neither is sufficient to affirm the judgment. 

 

The Battas argued the evidence was sufficient to support an easement by oral grant, and the appellate court disagreed. 

 

While easements must generally be conveyed in writing, an executed oral agreement will convey title to an easement. 

 

Thus, although an easement is an interest in real property and generally must be agreed to in writing, an oral agreement to grant an easement will be enforced where the grantee improves the easement and otherwise performs under the terms of the agreement. 

 

Here, the evidence relied on by the trial court to find an easement by oral grant was Hunt’s statements during the sales process and prior to purchase that there was an easement, and Hunt’s statement in the TDS where she described an easement for parking and trash bins. Hunt argues this evidence was insufficient to create an oral grant because Hunt’s statements during the sales process and before the sale could not modify the purchase agreement under the parol evidence rule, and the TDS was insufficient to constitute a separate agreement to grant an easement. 

 

The appellate court agreed with Hunt. 

 

When the parties to a written contract have agreed to it as an "integration"—a complete and final embodiment of the terms of an agreement—parol evidence cannot be used to add to or vary its terms.

 

Here, the parties do not dispute that the purchase agreement contained an integration clause. Nor do they dispute that the purchase agreement makes no mention of an easement. Further, the Battas did not argue that any of the purchase agreement’s terms are reasonably susceptible to their interpretation or that the terms are ambiguous such that parol evidence is necessary. 

 

Therefore, Hunt’s statements during the sales process that she was granting an easement in favor of the Batta Property constituted parol evidence that was inadmissible to vary the terms of the purchase agreement. 

 

LESSONS:

 

1.         During a sale transaction, all aspects of the property being purchased should be confirmed in written agreements, and special attention should be given to the relationship between adjacent properties.

 

2.         An easement is an interest in the land of another, which entitles the owner of the easement to a limited use or enjoyment of the other’s land. 

 

3.         An easement creates a nonpossessory right to enter and use land in another’s possession and obligates the possessor not to interfere with the uses authorized by the easement.

 

4.         Although an easement is an interest in real property and generally must be agreed to in writing, an oral agreement to grant an easement will be enforced where the grantee improves the easement and otherwise performs under the terms of the agreement. 

Will Contractor's Forged Signatures Allow Attorney's Fees?

In the recent case of Andrade v. Western Riverside Council of Governments, SanJuana Andrade appealed the trial court’s order denying an award of attorney’s fees pursuant to Civil Code section 1717.

Andrade claimed that contracts with defendant Western Riverside Council of Governments (Council) contained fee provisions that, when broadened by operation of section 1717, entitled her to recover her attorney’s fees. 

 

The appellate court agreed that section 1717 renders the fee provisions applicable and remanded to the trial court to determine whether Andrade is “the party prevailing on the contract” and thus entitled to fees. 

 

Andrade filed the lawsuit against the Council and others, claiming that she had been fraudulently enrolled in a Property Assessed Clean Energy (PACE) program. 

 

She alleged that contractors forged her signature on PACE loan agreements with the Council, resulting in a lien on her home and greatly increased property tax assessments she had not agreed to. 

 

Andrade’s first amended complaint, which added the Council as a party, sought to plead 12 causes of action, including multiple theories for rescission of the Council loan agreements. 

 

On her contractual causes of action, Andrade sought rescission of the loan agreements, restitution, “damages,” and declarations that the agreements were unenforceable in whole or in part. 

 

Following an investigation by the state Department of Financial Protection and Innovation (DFPI), which confirmed the contractors’ fraud, the Council released its assessment and the lien on Andrade’s property.

In 2021, it reimbursed Andrade for property tax payments she had been made toward the increased assessment. 

 

In 2022, Andrade filed a motion for attorney’s fees and costs. 

 

Among other theories, Andrade relied on section 1717, which provides "In any action on a contract, where the contract specifically provides that attorney’s fees and costs, which are incurred to enforce that contract, shall be awarded either to one of the parties or to the prevailing party, then the party who is determined to be the party prevailing on the contract, whether he or she is the party specified in the contract or not, shall be entitled to reasonable attorney’s fees in addition to other costs." 

 

Where a contract provides for attorney’s fees, that provision shall be construed as applying to the entire contract, unless each party was represented by counsel in the negotiation and execution of the contract, and the fact of that representation is specified in the contract. 

 

The court, upon notice and motion by a party, shall determine who is the party prevailing on the contract for purposes of this section, whether or not the suit proceeds to final judgment. The party prevailing on the contract shall be the party who recovered a greater relief in the action on the contract. The court may also determine that there is no party prevailing on the contract for purposes of this section. 

 

Andrade pointed to identical provisions in the two loan agreements that provide for attorney’s fees. 

 

The trial court denied Andrade’s motion. Although the court agreed the case was an action “on a contract” for purposes of section 1717, it concluded that the contractual fee provisions were limited in scope and did not entitle Andrade to attorney’s fees because they concerned fees for a judicial foreclosure action. 

 

The court found that the Council had not pursued judicial foreclosure and that Andrade had not set forth a clear case that Council even could pursue judicial foreclosure. Accordingly, the court denied the request for fees under section 1717. 

 

As an initial matter, the appellate court agreed with the trial court that this was an “action on a contract” within the meaning of the statute. 

 

It was undisputed that Andrade’s claims principally concerned whether the loan agreements were valid and enforceable. 

 

California courts liberally construe “on a contract” to extend to any action as long as an action "involves" a contract and one of the parties would be entitled to recover attorney fees under the contract if that party prevails in its lawsuit.

 

Under this standard, Andrade’s action, which applies contractual principles as to whether a contract is valid and enforceable, is an action “on a contract.” 

 

The Council argued to the contrary, contending that Andrade sought to invalidate the contract rather than enforce it. But it has long been settled that a party is entitled to attorney fees under section 1717 even when the party prevails on grounds the contract is inapplicable, invalid, unenforceable or nonexistent, if the other party would have been entitled to attorney’s fees had it prevailed.

 

The Council also argued that section 1717 covers only contract actions, where the theory of the case is breach of contract.

 

As an initial matter, that argument conflicts with the plain language of section 1717, which merely requires an “action on a contract,” not an action for breach of contract. It is also inconsistent with the weight of California authority. 

 

Fraud and negligence claims seeking to avoid obligations under a promissory note constitute action “on a contract".

 

A party’s entitlement to attorney fees under section 1717 turns on the fact that the litigation was about the existence and enforceability of the contract, not on the presence of particular contractual claims or a request for specific performance.

 

Actions for a declaration of rights based upon an agreement are "on the contract".

 

Whenever a party seeks to invalidate a supposed contract on grounds that an enforceable agreement never existed, and the party opposing such a claim implicitly contends there is a valid contract, the essential premise for section 1717 is satisfied. 

 

The appellate court held it would seem incongruously artificial to permit the award of attorney’s fees under section 1717 in situations where a party affirmatively sought to enforce a contract, but deny them where the same party made the same argument in a defensive posture. 

 

The trial court held that the fee provisions in the loan agreements only concern judicial forfeiture and thus do not apply here. 

 

Under section 1717, subdivision (a), however, a fee provision must be construed as applying to the entire contract, unless each party was represented by counsel in the negotiation and execution of the contract, and the fact of that representation is specified in the contract.

 

This portion of the statute was added by the Legislature in response to a Court of Appeal decision permitting contracting parties to limit an attorney’s fee clause to specific provisions of the agreement or a certain type of action.

 

The purpose of the amendment was to clarify to either party to any contract that provided for attorney’s fees” that they may not limit the forms of action to which attorney’s fees are applicable.

 

Following this amendment, parties may not limit recovery of attorney fees to a particular type of claim unless each party was represented by counsel in the negotiation and execution of the contract, and the fact of that representation is specified in the contract.

 

The Legislature thus expanded the statute to further its fundamental goal of ensuring a mutuality of remedy.

 

The circumstances of this case fall squarely within the purpose of the amended statute. 

 

The loan agreements provide that the Council could recover its fees in an action to enforce its rights through a judicial foreclosure proceeding. 

 

Throughout the action, Andrade sought to contest her obligations under the alleged agreements, thereby avoiding potential default and foreclosure. Limiting the fee provisions to foreclosure proceedings would be the precise kind of lopsided arrangement that section 1717 prohibits. 

 

Finally, the appellate court considered whether Andrade was “the party prevailing on the contract” for purposes of section 1717. 

 

Although both parties appeared to contend the trial court found that she was, the record did not support this conclusion as a matter of law. 

 

The court’s reasoning makes clear that it found Andrade was a “prevailing party” for purposes of awarding costs under Code of Civil Procedure section 1032. 

 

“Prevailing party” is specifically defined in that statute to include the party with a net monetary recovery.

 

The court found that Andrade qualified as the party with the "net monetary recovery".

 

The court did not, however, determine that Andrade was “the party prevailing on the contract” for purposes of section 1717. 

 

Section 1717 does not use the phrase “prevailing party” or incorporate the definition used in the costs statute. 

 

Rather, “the party prevailing on the contract” for purposes of section 1717 is “the party who recovered a greater relief in the action on the contract.” 

 

In the event of a simple, unqualified decision, courts may determine that a party prevailed on the contract as a matter of law. 

 

If neither party achieves a complete victory on all the contract claims, it is within the discretion of the trial court to determine which party prevailed on the contract or whether, on balance, neither party prevailed sufficiently to justify an award of attorney fees.

 

It is for the trial court, in the first instance, to determine whether there is a “party prevailing on the contract” by comparing the relief awarded on the contract claim or claims with the parties’ demands on those same claims and their litigation objectives as disclosed by the pleadings, trial briefs, opening statements, and similar sources. 

 

The prevailing party determination is to be made only upon final resolution of the contract claims and only by a comparison of the extent to which each party ha[s] succeeded and failed to succeed in its contentions.

In determining litigation success, the trial court should respect substance rather than form, and to this extent should be guided by equitable considerations.

 

LESSONS:

 

1.         California courts liberally construe “on a contract” to extend to any action as long as an action "involves" a contract and one of the parties would be entitled to recover attorney fees under the contract if that party prevails in its lawsuit.

 

2.         A party’s entitlement to attorney fees under section 1717 turns on the fact that the litigation was about the existence and enforceability of the contract, not on the presence of particular contractual claims or a request for specific performance.

 

3.         Actions for a declaration of rights based upon an agreement are "on the contract".

 

4.         Fraud and negligence claims seeking to avoid obligations under a promissory note constitute action “on a contract".

 

5.         Actions for a declaration of rights based upon an agreement are "on the contract".