Hill v. State Farm Mutual Automobile Insurance (166 Cal. App. 4th 1438, 2008)

Opinion

MALLANO, J.

In this nationwide class action, 50 million present and former policyholders of State Farm Mutual Automobile Insurance Company (State Farm) contend that during the class period, 1983 to 1998, State Farm breached a duty to pay billions of dollars in dividends and, as a result, created an excessive surplus.

State Farm moved for summary judgment based on the business judgment rule, asserting that the board of directors (Board) had made its financial decisions on an informed basis, in good faith, and with the honest belief that it was acting in the company’s best interests. Plaintiffs countered that the rule was not applicable because (1) the Board did not adequately consider whether to declare dividends but merely rubberstamped management’s recommendations; (2) the Board was not sufficiently informed about dividends; (3) the Board’s dividend practices were fraudulent or dishonest; and (4) the Board’s dividend decisions were totally without merit.

The trial court granted summary judgment, concluding that the business judgment rule applied as a matter of law. We agree. First, the Board could properly rely on information from State Farm’s management and actuarial department in its deliberative process. Second, the Board was sufficiently informed—through written financial materials, oral presentations from company officers, and discussions during Board meetings—to make independent decisions about dividends. Third, State Farm did not engage in fraud by failing to indicate in its insurance policies and bylaws that it paid dividends from certain sources of income and did not sell invested assets for that purpose. It had no duty to disclose that type of information. Nor was there anything fraudulent about the financial information annually sent to policyholders; it was based on audited reports prepared by independent accountants in compliance with state regulatory principles of accounting. Fourth, in applying the business judgment rule, a court does not consider the merits of a board’s decisions. Rather, the court focuses on the decisionmaking process to ensure that it was not tainted by fraud, oppression, illegality, or the like. Thus, plaintiffs’ attack on the merits of State Farm’s decisions is of no import. We accordingly affirm.

I

BACKGROUND

On June 17, 1998, plaintiffs filed this class action against State Farm, alleging that, as policyholders, they were entitled to dividends under their insurance policies and that State Farm had improperly withheld dividends in order to increase its “surplus.” The term “surplus” means an insurance company’s assets less liabilities. Put another way, “surplus” is the capital available to back up an insurer’s obligations under its policies.

Plaintiffs alleged that “State Farm breached its duty [to policyholders] by amassing surpluses far in excess of what State Farm reasonably needed to meet its present and future insurance obligations,” thereby reducing dividends. As relief, plaintiffs requested damages, attorney fees, and an injunction barring State Farm from pursuing the practices that had reduced the dividend payments.

The complaint set forth six causes of action: breach of contract, breach of the covenant of good faith and fair dealing, fraud, negligent misrepresentation, violation of the Consumers Legal Remedies Act (Civ. Code, §§ 1750-1784), and violation of the unfair competition law (Bus. & Prof. Code, §§ 17200-17209).

State Farm demurred to the complaint on the ground that the payment of dividends was subject to the discretion and business judgment of the Board. Plaintiffs filed opposition. By order dated October 16, 1998, the trial court sustained the demurrer without leave to amend as to the cause of action under the Consumers Legal Remedies Act. On the remaining claims, the trial court sustained the demurrer with 20 days’ leave to amend. The trial court also instructed plaintiffs to attach their insurance policies to the amended complaint.

On October 27, 1998, plaintiffs filed a first amended complaint, realleging the five causes of action that survived the demurrer. In essence, plaintiffs alleged that State Farm had overstated its losses and understated its income so as to reduce the dividends to policyholders. Plaintiffs attached their policies, as instructed.

Between 1983 and 1989, the policies in most states provided, “[T]he first insured named in the declarations is entitled ... to share in the earnings and savings of the company in accordance with the dividends declared by the Board of Directors on this and like policies.” After 1989, the policies in most states read, “[T]he first insured named in the declarations is entitled ... to receive dividends the Board of Directors in its discretion may declare in accordance with reasonable classifications and groupings of policyholders established by such Board.” (Italics added.)

Further, in a newsletter sent to California policyholders in 1998, State Farm described dividends as “a return of part of your premium because claim costs were less than anticipated.” The newsletter also stated that “[o]ur goal as a mutual company is to put your interests first.”

Throughout the class period, the bylaws of State Farm provided: “Subject to the provisions of law regarding return of excess premiums, the Board of Directors may authorize from time to time such refunds or credits to policyholders from the savings and gains of the Corporation and upon such terms and conditions and in such amounts or percentage as may, in their judgment, be proper, just and equitable.”

A. Demurrer to Amended Complaint

On November 23, 1998, State Farm filed a demurrer to the first amended complaint, arguing again that the Board had properly exercised its discretion and business judgment with respect to declaring dividends. Plaintiffs filed opposition.

In January 1999, the trial court, Commissioner Bruce E. Mitchell presiding, sustained the demurrer without leave to amend as to all causes of action and entered a judgment of dismissal. Plaintiffs filed a timely appeal.

On January 30, 2001, Division One of this district filed a split decision, reversing the judgment of dismissal and reinstating the claims for breach of contract, breach of the covenant of good faith and fair dealing, and violation of the unfair competition law (Hill v. State Farm Mutual Automobile Insurance Co. (Jan. 30, 2001, B133262) [nonpub. opn.] (State Farm I)). The court concluded that plaintiffs had adequately pleaded their claims under California law and that an accounting would be an appropriate remedy if plaintiffs prevailed on the contract or covenant claim.

In rejecting State Farm’s contention that the action was barred by the business judgment rule, the court distinguished this division’s decision in Barnes v. State Farm Mut. Auto. Ins. Co. (1993) 16 Cal.App.4th 365 [20 Cal.Rptr.2d 87] (Barnes). The court explained that, in Barnes, “a policyholder sued State Farm Auto, seeking to ‘compel [it] to distribute “its unjustifiably large surplus” back to its policyholders.’ (Id. at p. 370.) The plaintiff alleged that ‘State Farm had accumulated a surplus fund consisting of premiums and investment income in excess of $10 billion . . . [and] that such conduct by State Farm amounted to an unjustified hoarding of surplus funds, for no legitimate business purpose and all to the detriment of policyholders who otherwise could have received either reduced premium rates or substantial dividends.’ (Ibid.)

“In Barnes, the trial court sustained State Farm Auto’s demurrer without leave to amend. The Court of Appeal affirmed, stating:

“ ‘Whether “a private corporation should declare and pay a dividend, or make a distribution of its assets is a matter committed to the sound business judgment of the corporation’s board of directors.” ... It is thus the general rule that a court will not interfere with a corporate decision to withhold dividends in the absence of a showing of abuse of the wide discretion which the courts grant to corporate directors.

“ ‘As one California court recently summarized the rule, “The common law ‘business judgment rule’ refers to a judicial policy of deference to the business judgment of corporate directors in the exercise of their broad discretion in making corporate decisions. The business judgment rule is premised on the notion that those to whom the management of the corporation has been entrusted, and not the courts, are best able to judge whether a particular act or transaction is one which is ‘ . . helpful to the conduct of corporate affairs or expedient for the attainment of corporate purposes . . . ’ and establishes a presumption that directors’ decisions are based on sound business judgment.

“ ‘[In Barnes, the plaintiff], although attempting to plead [around] this rule, has failed to allege facts showing that the [directors’] decision regarding the accumulation of State Farm’s surplus was not made in good faith or in what the directors believed to be the best interests of the corporation. He has alleged no facts demonstrating fraud, oppression, corruption or conflict of interest by the directors. [H]e appears to rest his claim upon the singular proposition that State Farm’s surplus and dividend policy differs significantly from an industry average. This is clearly insufficient to permit a court to interfere in the management of an apparently successful corporate enterprise.’ ([Barnes], supra, 16 Cal.App.4th at pp. 378-379, citations and fns. omitted.) ‘More is needed to establish an exception to the [business judgment] rule than conclusory allegations of improper motives and conflict of interest.’ ” (State Farm I, supra, B133262.)

After quoting from Barnes, Division One continued: “In the present case, plaintiffs alleged that State Farm’s decisions with respect to dividends were not made in good faith. ...[][]... [Plaintiffs alleged that the board of directors had improperly withheld dividends by (1) overstating underwriting losses, (2) understating investment income, (3) excluding from operating return the investment income derived from [State Farm’s] surplus, and (4) falsely claiming that [the] surplus had to cover the obligations of [State Farm’s] affiliated insurance companies.

“Thus, far from relying on conclusory allegations, plaintiffs point to several objective criteria in challenging State Farm’s alleged wrongful conduct. This is not a case where the policyholders merely ‘rest [their] claim upon the singular proposition that State Farm’s surplus and dividend policy differs significantly from an industry average.’ ([Barnes], supra, 16 Cal.App.4th at p. 379.) Moreover, under State Farm’s overly broad interpretation of the business judgment rale, virtually every decision of the board of directors, regardless of the circumstances, would enjoy absolute immunity.

“We are unpersuaded by State Farm’s dire prediction that plaintiffs’ claims, if allowed to stand, will put the courts in charge of the boardroom. Courts are not empowered to substitute their judgment for that of the board. A [determination] of liability would have to take into account that ‘directors should be given wide latitude in their handling of corporate affairs because the hindsight of the judicial process is an imperfect device for evaluating business decisions.’ . . . Similarly, any determination of liability would have to take into consideration that the business judgment rale ‘afford[s] directors broad discretion in making corporate decisions and . . . allow [s] these decisions to be made without judicial second-guessing ....’” “[T]he business judgment rale provides ample protection for the board’s lawful decisions. [][]... [f]

“We emphasize that this appeal raises a narrow question at the pleading stage: Did plaintiffs sufficiently allege that [State Farm’s] directors engaged in bad faith conduct in deciding to declare dividends or in setting the amount thereof? The answer is yes. The first amended complaint alleged that the board[] . . . improperly manipulated objective criteria ([for example,] general expenses, underwriting losses, investment costs) in order to overstate losses and understate income, all for the purpose of reducing dividends to policyholders. We cannot say that the business judgment rale bars plaintiffs’ claims at this point in the litigation.” (State Farm I, supra, B133262, citation omitted.)

On June 1, 2001, plaintiffs filed a second amended complaint, realleging the same claims and material allegations.

After the pleading stage, the trial court certified a nationwide class of 50 million present and former State Farm policyholders, five million of whom reside in California, for the period 1983 through 1998.

B. Petition for a Writ of Mandate

On March 24, 2003, State Farm filed a motion in the trial court to resolve a conflict of laws issue: whether the substantive law of Illinois—where the company was incorporated—or California—where the suit was filed— governed plaintiffs’ claims. State Farm argued that Illinois law applied because corporate decisions about dividends involved the internal affairs of the company, and, consequently, the law of the state of incorporation should govern. Plaintiffs asserted that California law controlled. By statement of decision filed on May 21, 2003, the trial court, Judge Charles W. McCoy presiding, ruled that California law applied because a breach of contract claim is not subject to the business judgment rule.

State Farm promptly filed a petition for a writ of mandate with this district. The petition was assigned to Division One, which issued an order to show cause. After briefing and oral argument, the court vacated the trial court’s decision and held, in a published opinion, that substantive Illinois law applied, including the Illinois business judgment rule (State Farm Mutual Automobile Ins. Co. v. Superior Court (2003) 114 Cal.App.4th 434, 442-451 [8 Cal.Rptr.3d 56] (State Farm II)). The court said: “ ‘Every State in this country has enacted laws regulating corporate governance. By prohibiting certain transactions, and regulating others, such laws necessarily affect certain aspects of interstate commerce. . . . This beneficial free market system depends at its core upon the fact that a corporation—except in the rarest situations—is organized under, and governed by, the law of a single jurisdiction, traditionally the corporate law of the State of its incorporation.’ . . .

“ ‘The internal affairs doctrine is a conflict of laws principle which recognizes that only one State should have the authority to regulate a corporation’s internal affairs—matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders— because otherwise a corporation could be faced with conflicting demands.’ . . . ‘States normally look to the State of a business’ incorporation for the law that provides the relevant corporate governance general standard of care.’ . . .

“ ‘Internal affairs’ include ‘ “steps taken in the course of the original incorporation, ... the adoption of by-laws, the issuance of corporate shares, the holding of directors’ and shareholders’ meetings, . . . the declaration and payment of dividends and other distributions, charter amendments, mergers, consolidations, and reorganizations, the reclassification of shares and the purchase and redemption by the corporation of outstanding shares of its own stock.” ’ . . .

“. . . ‘It would be impractical to have matters . . . which involve a corporation’s organic structure or internal administration[] governed by different laws. It would be impractical, for example, if ... an issuance of shares, a payment of dividends, a charter amendment, or a consolidation or reorganization were to be held valid in one state and invalid in another. . . .’ ” (State Farm II, supra, 114 Cal.App.4th at pp. 442-443, citations omitted.)

In addressing the trial court’s reasoning, the court also stated: “In the present case, State Farm policyholders challenge the board of directors’ decision whether to declare dividends. The policyholders rely on the language in their policies, a newsletter, and the bylaws, contending they have a contractual right to dividends that must be honored in accordance with their reasonable expectations. . . .

“. . . [T]he policyholders [argue that] their right to dividends should be adjudicated under contract law, the business judgment rule notwithstanding. And the trial court commented, ‘[State Farm is] not going to be able to use . . . corporation law as a trump over that contractual obligation.’ But the business judgment rule, which accords deference to the decisions of the board of directors, is reflected in the language of State Farm’s policies, newsletter, and bylaws. The rule is, in essence, written into the contract.

“Simply put, the policyholders challenge a decision of the board of directors that falls within State Farm’s internal affairs. The causes of action in the complaint, though labeled in common terms—breach of contract and breach of the covenant of good faith and fair dealing—involve ‘matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders As to those matters, the law of State Farm’s place of incorporation, Illinois, applies . . ., not California’s law on contracts ....

“In other words, ‘[t]he law applicable to a contract dispute . . . does not control claims relating to the internal affairs of the corporation.’ . . . ‘[T]he plaintiff s contention that this suit[,] being one on a contract^] does not involve the internal affairs of a foreign corporation is without merit.’ ” (State Farm II, supra, 114 Cal.App.4th at pp. 446-447, citations omitted.)

The court also discussed the business judgment rule under Illinois law. “ ‘The business judgment rule is a presumption that directors of a corporation make business decisions on an informed basis, in good faith, and with the honest belief that the course taken was in the best interests of the corporation. . . . Like most rebuttable presumptions, it arises by operation of law. . . . However, the plaintiff may rebut the presumption by presenting evidence that the directors] acted fraudulently, illegally, or without becoming sufficiently informed to make an independent business decision. ... [f]...[][].. . The burden is on the party challenging the decision to present facts rebutting the presumption.’ ” (State Farm II, supra, 114 Cal.App.4th at p. 450.) An Illinois court had put it this way; “ ‘The decision concerning the declaration of a dividend where a legal dividend fund is available rests within the sole discretion of the board of directors. Courts are reluctant to interfere with the exercise of the directors’ business judgment unless the withholding is fraudulent, oppressive or totally without merit.’ ” (Ibid.) And a third court had stated the business judgment rule protected the directors’ decision absent a showing of “ ‘fraud, oppression, or dishonest conduct.’ ” (Ibid., italics omitted.)

The court summarized these various formulations, concluding: “[A]bsent one of the exceptions to the business judgment rule—fraud, oppression, dishonesty, total lack of merit, illegality, or a failure of the board of directors to become sufficiently informed to make an independent decision—a corporation is not liable for a lack of dividends.” (State Farm II, supra, 114 Cal.App.4th at p. 451.)

Further, as to plaintiffs’ causes of action, the court pointed out the differences between the covenant of good faith and fair dealing under California and Illinois law. In Illinois, the covenant provides a cause of action, sounding in tort, only where an insurer breaches a duty to settle a third party claim against the insured. (State Farm II, supra, 114 Cal.App.4th at p. 451.) With that exception, the covenant does not support an independent cause of action or permit the recovery of tort damages. (Id. at pp. 451-453.) Rather, it is a rule of construction used “ ‘to determine the intent of the parties where a contract is susceptible to two conflicting constructions.’ . . . ‘ “[W]here an instrument is susceptible of two conflicting constructions, one which imputes bad faith to one of the parties and the other does not, the latter construction should be adopted.” ’ ” (Id. at p. 452, citation omitted; accord, Fox v. Heimann (2007) 375 Ill.App.3d 35, 42 [313 Ill.Dec. 366, 374, 872 N.E.2d 126, 134]; Mid-West Energy Cons. v. Covenant Home (2004) 352 Ill.App.3d 160, 163-164 [287 Ill.Dec. 267, 270-271, 815 N.E.2d 911, 914-915]; St. Mary’s Hosp. v. Health Pers. Options (1999) 309 Ill.App.3d 464, 469-470 [242 Ill.Dec. 682, 686, 721 N.E.2d 1213, 1217]; Perez v. Citicorp Mortgage, Inc. (1998) 301 Ill.App.3d 413, 423-424 [234 Ill.Dec. 657, 664, 703 N.E.2d 518, 525].)

And even where the covenant applies, “ ‘ “[p]arties are entitled to enforce the terms of negotiated contracts to the letter without being mulcted for lack of good faith.” . . . “Express covenants abrogate the operation of implied covenants so courts will not permit implied agreements to overrule or modify the express contract of the parties.” ’ ” (State Farm II, supra, 114 Cal.App.4th at p. 453.)

Finally, the court discussed the nature of a mutual, as opposed to a stock, insurance company. “State Farm is a mutual insurance corporation. As such, it ‘issues no capital stock and is cooperatively owned by its policyholders, who are both the insurers and the insureds

“ ‘Mutual insurance companies are organized, maintained, and operated solely for the benefit of their policyholders .... Such companies do not generate traditional entrepreneurial profits, but rather seek to meet their obligations at the lowest possible cost to the policyholders who, by paying premiums, provide the companies’ exclusive source of capital.’ . . .

“ ‘Policyholders in mutual companies are denominated “members” of the company; their ownership rights in the company are their “membership interests.” Members of mutual insurance companies have many of the same rights as stockholders in corporations, including the right to vote and the right to residual surplus upon liquidation.’ . . .

“State Farm does not offer insurance policies as investment opportunities but instead provides policyholders with protection against loss. In contrast, a stock insurance company seeks to earn a profit for the benefit of its stockholders, who may or may not be policyholders. . . .

“ ‘[M]utual insurers have greater difficulty [than stock insurers] in raising capital to fund growth, and hence, must rely to [a] greater extent on accumulated surplus and income from new members to support growth. . . . [M]anagers of mutual insurers tend to exercise more discretion which tends to favor long-term stability over greater risk.’ ” (State Farm II, supra, 114 Cal.App.4th at pp. 440-441, citations omitted.)

After the court granted State Farm’s petition, the case returned to the trial court for additional proceedings.

C. Motion for Summary Judgment

In October 2005, State Farm filed a motion for summary judgment or, in the alternative, for summary adjudication as to each cause of action. State Farm argued that the business judgment rule, as applied in Illinois, barred the action in its entirety. In support of summary adjudication, State Farm asserted (1) the contract claim failed because the insurance policies and bylaws did not accord plaintiffs an enforceable right to dividends at any time or in any amount; (2) a separate cause of action for breach of the covenant did not exist under Illinois law; and (3) the unfair competition law did not apply because it was a California statute. State Farm submitted declarations and exhibits in support of the motion. Plaintiffs filed evidence in opposition.

1. State Farm’s Evidence

State Farm based the price of its automobile policies—its premiums—in part on actuarial data obtained from each state. Its underwriting goal was to sell policies at an affordable price so that total premiums would equal total losses and expenses. Thus, the company attempted to break even on the sale of insurance. At the same time, State Farm maintained a surplus on which it earned investment income. The company would use that income in the event of an operating loss. During the class period, State Farm generally paid dividends if its underwriting results were better than expected. The company did not sell assets from the surplus to pay dividends. Rather, the assets provided a source of funds for catastrophes and allowed the company to charge low premiums and reduce rates.

In 1983, when the class period began, the Board consisted of 11 members. By 1998, the last year of the period, the Board had grown to 13 members. The Board met quarterly—in March, July, September, and December—at State Farm’s headquarters in Bloomington, Illinois. Those meetings consisted of a series of presentations over a two-day period. State Farm’s officers, some of whom were also directors, made oral reports on State Farm’s finances, operations, investment activities, pension funds, and audit results. The presentations led to discussions among the directors on those topics.

During the year, the directors received numerous written financial reports, such as (1) monthly “Financial Statements” (around eight pages in length), showing a breakdown of assets, liabilities, and surplus; (2) quarterly “Operations Reviews” (around eight pages), which set forth underwriting profits and losses, and investment activity by category; (3) “Quarterly Statements” (around 64 pages), providing detailed information about the company’s financial condition, including line-item data about increases and decreases in surplus; (4) an annual “Report on Audits of Financial Statements—Statutory Basis” (around 27 pages), prepared by Coopers & Lybrand (Audited Reports), listing subcategories and the corresponding amount of income, losses, and surplus; and (5) the “Annual Statement” (of varying lengths, up to 305 pages), consisting of multiple “schedules” of specific information on the company’s overall financial condition, including surplus.

The monthly and quarterly financial statements, together with the quarterly operations reviews, enabled the directors to track profits, losses, and the size of the surplus on a continuing basis. State Farm invested its surplus, primarily in stocks, bonds, and real estate.

The surplus consisted of five categories: (1) “catastrophe reserve— reinsurance,” which provided a source of protection in the event of a catastrophe; (2) a minimum “Guaranty Fund” required by statute; (3) unassigned funds, which represented the unassigned retained earnings of the company; (4) unrealized capital gains; and (5) funds to protect the policyholders of State Farm’s subsidiaries (also called affiliates), namely, State Farm Life Insurance Company and State Farm Fire and Casualty Company.

Vincent Trosino held a managerial position with State Farm beginning in 1972, becoming a member of the Board in 1987. From 1987 to 1990, he was vice-president, chief administrative officer; from 1991 to 1998, he was executive vice-president, chief operating officer; and in 1998, he assumed the position of president, chief operating officer. Trosino testified that the Board’s quarterly meetings involved “interactive” presentations by several officers, including himself. “These discussions,” he said, “combined with the written materials provided to the Board, allowed the Directors to gain a good, working understanding of the essential aspects of [State Farm's] operations and finances, including its surplus position and how that position was evolving.”

Since 1987, Trosino has served as an officer-director in considering and determining the level of State Farm’s surplus, and in considering, recommending, and voting upon whether to declare a dividend as well as the amount of the dividend. He periodically reviewed State Farm’s financial performance and surplus level with the company’s actuarial department. Those reviews involved constant monitoring of the surplus, profits and losses, and income from all sources, including investments, and examining whether conditions warranted a dividend and, if so, the amount.

According to Trosino: “Ultimately, the appropriate range of surplus is not a matter of a single rating or ratio, but rather is a matter of judgment that is exercised by senior officers and our Board of Directors, and I have participated directly in making these judgments during the period 1987 to the present. . . . [f] . . . [The] surplus supported [State Farm’s] ability to meet the needs of its policyholders, remain competitive, charge lower premiums, and support the reasonable growth of its business. ...[][]... During discussions among the Board of Directors, we concluded that retaining [capital gains] as additions to our surplus was the wisest course of action and in the best interests of our policyholders. This growth in surplus added to our ability to provide financial protection to our policyholders and, in addition, added to our ability to reduce rates or lessen the size of rate increases to our policyholders. Had we determined to liquidate any significant portion of our surplus in order to pay a one-time dividend, it would have reduced both our financial strength and our ability to reduce or lessen the size of increases of rates and premiums . . . .” State Farm typically did not liquidate long-term investments except in catastrophe situations. The Board was opposed to “dividending out,” or selling, an asset in the surplus to pay a dividend. On the other hand, State Farm had no problem using money generated by short-term investments in the surplus, for example, maturing treasuries. That money was used “to offset the cost of operations,” such as an underwriting loss.

Trosino recommended that the Board declare dividends primarily when State Farm’s underwriting return exceeded its underwriting targets for the previous 12 months or so. By the same token, a dividend was usually not recommended if the company had greater than anticipated losses on its policies. Trosino’s recommendations were based on a state-by-state analysis. Under this method, policyholders received a dividend if they lived in a state that produced higher income than the “target underwriting return” for that state. If policyholders did not live in such a state, they did not receive a dividend. In making a dividend decision, the Board used a “worksheet” that showed the pertinent underwriting statistics for each state.

Trosino also considered the financial effect of natural disasters. For instance, he did not recommend dividends in 1989, 1990, 1995, or 1996—in light of Hurricane Hugo (1989), other catastrophes (1990), and the uncertain situation after the Northridge earthquake (post-1994); during those times, the level and cost of auto insurance claims rose significantly, and underwriting losses were much greater than expected.

This approach allowed the surplus to grow during the class period—mainly through investment return—from $8.2 million in 1983 to $41.8 billion in 1998, as indicated in the Audited Reports. According to State Farm and plaintiffs’ expert witnesses, the Board declared dividends in 10 years of the 15-year class period, totaling $2.87 billion, as shown below.

April 1983: $69,600,000

April 1984: $133,560,000

November 1987: $202,700,000

November 1988: $157,000,000

December 1991: $198,500,000

August 1992: $169,300,000

October 1993: $205,900,000

April 1994: $187,500,000

November 1997: $651,000,000

June 1998: $891,600,000

In making dividend recommendations to the Board, Trosino relied in part upon input from the actuarial department. Gregory Hayward, an assistant vice-president and actuary who has been with State Farm since 1979, described the work of the company’s actuaries. They conducted an ongoing actuarial analysis of the financial position and needs of State Farm for use by senior management in assessing the company’s surplus, rates, and dividends. Hayward, who heads the research unit of the actuarial department, routinely monitored and analyzed State Farm’s surplus levels and reviewed his findings with at least one key officer and member of the Board.

The actuarial department maintained a close watch on gains and losses, expenses, and State Farm’s overall financial condition and had an ongoing dialogue with management as to whether a dividend or rate reduction should be recommended to the Board. In the years when a dividend was not recommended, State Farm had usually suffered greater than anticipated losses on its policies. For instance, a dividend was not recommended in 1995 or 1996 because State Farm had suffered underwriting losses in the preceding years—$1.65 billion in 1994 and $1.22 billion in 1995. In the latter half of 1996, underwriting results improved, yielding a profit of $594 million for the year. As a result, a dividend was declared in 1997.

State Farm did not have a practice or rule against declaring dividends in the event of an underwriting loss. In Hayward’s words, “We [took] into consideration all of the financial aspects of file company.” He pointed out that State Farm also earned investment income on nonsurplus items such as reserves: unearned premium reserves and loss expense reserves. If a dividend was declared notwithstanding an underwriting loss, State Farm would still use underwriting results, as opposed to investment income, to choose the states in which to pay dividends.

As one director testified, the Board considered at least three factors in deciding whether to declare a dividend: underwriting results, net income before taxes (including interest and dividends earned on the surplus), and the net worth of the company. There were several years—1987, 1988, 1991, and 1992—in which State Farm declared a dividend even though it had incurred an underwriting loss that year and the preceding year.

Roger Joslin was a principal financial officer of State Farm since 1969 and a director since 1988, continuing in both capacities until his retirement in 2002. He also participated in considering, recommending, and voting for dividends. In July 1987, Joslin, then the company’s treasurer, drafted a “memorandum to file,” stating: “The Board of Directors has broad discretion concerning declaration of dividends to policyholders. Nothing, including past practices, dictates how dividends shall be apportioned.” As noted by Joslin, when a dividend recommendation was made to the Board, the directors gave it “due consideration.”

Wendy Gramm, a director from 1994 to 2002, who had served as chair of the United States Commodity Futures Trading Commission, recalled that “I or others on the Board did ask a lot of questions of State Farm management on their dividend proposals.” Dr. Robert Jaedicke, a director from 1991 to 1999, and a former dean of the Stanford Graduate School of Business, referred to the discussion of dividends as an “interactive session” that was “sometimes rather lengthy”—possibly “half of the morning meeting” with “continual discussion and questions from Board members and comments from officers.”

Dr. James Wilson, a professor at the University of California at Los Angeles and a member of the Board beginning in 1995, remembered a 1997 meeting in which management proposed a dividend. The Board voted in favor of a dividend after what he called “considerable discussion.” Asked at his deposition about that part of the meeting, Wilson said, “Any timé we discuss the financial conditions of the company, there is an extended discussion.”

If Trosino or another officer recommended a dividend, then the Board declared one. If such a recommendation was not made, a dividend was not declared. But a dividend might still have been discussed. Trosino explained that if he recommended a rate cut, for example, directors sometimes asked questions about declaring a dividend. The Board would discuss the issue and eventually conclude that it wanted to keep rates as competitive and low as possible and would approve the recommended rate cut. Director Gramm testified that the Board discussed rate cuts in terms of competition and providing a good value to policyholders. To Gramm’s best recollection, the Board consistently approved what the officers recommended, be it a dividend or a rate cut. Some Board members would ask questions about the particular recommendation, but they were ultimately satisfied with the answers they received. As Gramm said, “[B]y the time we got to actual votes, . . . people on the board were comfortable with the proposals so that, in fact, we operated more like a collegial body.” But she did not recall any occasion when management contemplated a rate cut “in lieu of payment of dividends.”

In 2000, Hayward completed an eight-page actuarial report for Trosino and the Board, analyzing the size of the surplus as of the end of the previous year. He concluded that the surplus is “strong and provide[s] our policyholders with superior protection and value at very competitive prices. The risk of ruin, while not zero, is acceptably low. The [surplus is] within a range of reasonableness. The funds are neither inadequate nor excessive giving due consideration to the extraordinary and unique risks and best interests of our policyholders.” The report was based on three different mathematical methods or models, all described in detail. Although Hayward finished the report after the class period, he testified: “While in prior years [the] Actuarial Department had not prepared formal [reports] in this format, [the 2000 report] illustrates the type of surplus analysis that we performed going back many years. ... In the years prior to 1999, State Farm’s Actuarial Department analyzed [the surplus] using similar methods and techniques. Each year, [the] Actuarial Department advised executive management about the level and adequacy of surplus[:] [T]he size [of the] surplus was reasonable and not excessive. . . . Based upon [the] ongoing analysis of surplus, [the] Actuarial Department has never concluded that [the] surplus was excessive or ‘too high.’ ”

The actuarial department did not believe it would be prudent to sell any assets in the surplus for purposes of declaring a dividend. To do so, the actuaries thought, would have eliminated assets as a source of future growth and income, and reduced the ability to charge stable and low insurance rates and premiums. The strength of the surplus also permitted State Farm to implement rate reductions—totaling approximately $437 million—beginning in the second half of 1996 and continuing through 1997. In 1998, State Farm reduced its target underwriting return from zero percent to minus five percent in all states, due in large part to the increase in the surplus. The company made an intentional decision to sell policies at a loss, relying on investment income to remain profitable. From 1997 through 2000, State Farm implemented rate reductions totaling nearly $3 billion.

In his declaration, Hayward described how the insurance industry uses “ratios” as “shorthand expressions ... to reflect the amount of surplus that exists in relation to an insurer’s premium.” A “surplus-to-premium ratio” of “1 to 2” means that for every dollar of surplus (the numerator), there are two dollars of premium (the denominator). This is a ratio of 0.50 and is commonly referred to as a surplus level of “50 cents.” But the risk exposure from a specific policy vastly exceeds the premium and can vary greatly from one type of policy to the next. For instance, an auto policy with a premium of $500 might have a potential exposure of $100,000; viewed in isolation, that policy would require more than 50 cents for each dollar of premium. Thus, the insurance industry does not rely solely on surplus-to-premium ratios to indicate the appropriate level of surplus. This is perhaps most evident in State Farm’s filings with state regulators in which it represented that a 0.50 ratio is “prudent.” That representation merely indicated the minimum amount of surplus needed for ratemaking purposes. State regulators are concerned with preventing insolvency and focus on whether the surplus is adequate, not whether it is excessive: They consider 0.50 adequate and any ratio below 0.33 to be a sign of potential insolvency. In addition, State Farm disclosed its actual total surplus to regulators and was never informed that the 0.50 ratio is a maximum or that a dividend was warranted. Hayward’s declaration is consistent with the testimony that State Farm’s chief actuary, Thomas Morrill, gave before Congress in 1969.

State Farm did not adopt a fixed ratio for evaluating its surplus, but it did address the subject of ratios more than once in writing. On October 31, 1985, Dale Nelson, a State Farm actuary, sent a draft memorandum to Alan Curry, a vice-president and actuary, stating that the “increase [in the surplus] has caused some to question whether State Farm has ‘surplus’ surplus.” After providing a three-page analysis of that issue, Nelson concluded: “State Farm finds itself in a position where it must stand on its own—there is no one else with the financial resources to back it up. For anyone to argue, then, that State Farm has too much surplus is to ignore present day realities.” In an “Office Memo” to Curry, dated March 5, 1986, Nelson devoted eight pages to the same topic, noting that a ratio “in the 0.50—>0.75 range is not overly conservative” for State Farm. A June 1991 memo, consisting of seven pages, asked, among other things, “What is the ‘right’ . . . surplus ratio for State Farm?” The answer, as set forth in the memo, was: “State Farm does not have a specific target, which we believe is file appropriate ratio. It is our objective to be financially able to fulfill our obligations to policyholders. We believe that a [surplus-to-premium] ratio stronger . . . than [0.50] is needed to accomplish that objective.” (Original underscoring.)

An August 31, 1991 actuarial report, co-authored by Nelson and chief actuary Gary Grant, was given to the Board. The report consisted of 14 pages, three exhibits, and four appendices. After discussing several theories and factors, it concluded: “Considering the multiplicity and magnitudes of risks involved, the [surplus] could never be too large for absolute assurance of all obligations to customers. However, there are practical limits on how large the . . . surplus can become. Competition is the major constraint. Regulatory views and public perceptions are also important, [f] Considering all factors, it seems prudent for State Farm to maintain at least 500 of unassigned surplus for every dollar of premium written and for the Fire Company to have an additional 150 of surplus available for catastrophe losses which exceed those provided in the rates. When circumstances allow, earnings should be used to build and maintain a higher level. A level as high as 750 or even $1 appears to be sustainable, strictly from the standpoint of its effect on insurance rates and State Farm’s competitive position.” As Grant testified at his deposition, he did not reach any conclusions about an appropriate level of surplus. Rather, he and Nelson wrote the report so that management could evaluate the size of the surplus.

Once a year, the directors received a “Financial Review of Selected Property and Casualty Insurance Groups” prepared by State Farm’s research department. A portion of the report, entitled “Analysis of Surplus/Best Underwriting Ratios,” compared and discussed the surplus-to-premium ratios of several insurance companies. From 1990 to 1996—the only years covered in the record—one or more of State Farm’s competitors had a higher ratio than State Farm. For instance, in 1994, three of State Farm’s 11 competitors—Aetna, Safeco, and United Services Automobile Association—had higher ratios.

According to State Farm, its surplus-to-premium ratios for 1983 to 1995 ranged from 0.59 to 0.78; in 1996, the ratio was 0.90; in 1997, 1.11; and in 1998, 1.26. (Plaintiffs’ calculations for 1983 to 1995 indicated that State Farm’s ratios ranged from 0.87 to 1.05; in 1996, the ratio was 1.20; in 1997, 1.49; and in 1998, 1.69.) The industry average during the class period ranged from 0.52 to 1.19.

Director Joslin, who served as treasurer for many years, confirmed that at “many” Board meetings, there were discussions regarding the “appropriate” level of surplus. At each meeting, Joslin or a member of his staff reviewed the company’s surplus position. At no time did the Board conclude that the surplus exceeded reasonable limits.

As director Jaedicke stated: “[A]t every meeting we had a financial report which included the increases in surplus, as well as the increases in the various categories of the surplus. And that was always part of the discussion, part of the consideration at every meeting that I could recall.” Jaedicke did “not recall anybody on the Board of Directors suggesting that somehow we ought to weaken [our] financial condition by monetizing some asset or set of assets and paying a dividend.” During his deposition, Jaedicke was asked about the surplus and replied: “I find it difficult to respond when you say did we ever discuss whether we had surplus surplus, which would indicate we felt we had too much. • • • HO . . . [f] . . . [I]mplicit in [our] discussion [of surplus] would be whether you had too much. That was not where the focus was. Nobody felt that way.” He also commented: “Usually, once a year we compared ourselves with the industry. [T]hat was another occasion on which the size of the surplus would be discussed.”

Stressing the importance of surplus, director Wilson said that the Board wanted to “feel comfortable that should there be a series of catastrophes in [the] near future, we would have enough money to pay all of the policyholders.” He added: “I think we were assured by the performance of the market that our net worth was going up. But, as you know, we carry unrealized capital gains on the books as a separate item, [k]nowing, as we do, as everyone should know, that the market is volatile. What is a gain one year could be a loss in the subsequent years.” Wilson acknowledged that “[t]here could be in principle ‘too much net worth’ ”—surplus—but went on to say, “[i]n my judgment, as a director for the seven or so years that I’ve been on the board, we’ve never been in a position where we had too much, [f] In fact, right now, I think we have too little.” “I think the net worth has been inadequate to prudently run State Farm . . . .”

During Director Gramm’s eight years on the Board, the directors “did look at especially the ratios of . . . surplus-to-premium ... all the time. And at some times the surplus was . . . lower than others.” Gramm “always felt more comfortable if the surplus to premium [ratio] was closer to one—if not above it—than one half, which was kind of a regulatory minimum.” She did not recall State Farm’s “focus[ing] on one number that was an important ratio.” At every quarterly meeting, the directors reviewed “these numbers,” and “given the catastrophes and the hail storms and the hurricanes . . . , [Gramm] had concern about the size of the surplus. . . . [T]hose ratios helped quantify that.” She recalled that State Farm’s “ratios were not as favorable as some of its competitors’ [ratios].” The company did not view the ratios as binding or determinative in making decisions but regarded them as a reliable indicator of its financial condition. “[T]he ratio itself is just one measure,” Gramm said.

Actuary Hayward testified that the surplus was also crucial in protecting the financial condition of State Farm’s subsidiaries. As he put it, the subsidiaries “add great risk” to State Farm. After several natural disasters, State Farm “recapitalized” its wholly owned companies. For instance, it recapitalized State Farm Fire and Casualty Company after Hurricane Andrew in 1992, provided surplus notes to its Florida company after other hurricanes, and, after disasters in California, provided capital and surplus notes to a State Farm company that writes homeowners insurance here.

When asked at his deposition why State Farm did not sell any of the assets in the surplus to pay dividends, Trosino said that State Farm’s business “model” is “to provide for our policyholders at the lowest cost possible a policy . . . that will live up to our obligations to pay them and that we will have the wherewithal to do that come what may. And in doing so, as a mutual company where we only raise our capital through retained earnings or build our capital through retained earnings, we believe our surplus position has to be very, very strong. And that has served us well for over 80 years and being the number one insurer of automobiles and having the highest retention rate of any large company, ... the model. . . has proven to be successful with our policyholders.”

Finally, each year, State Farm prepared a one-page insert, entitled “Annual Report to Policyholders,” which was included with the policyholders’ premium notices. The insert contained a short message from the chairman. For example, the 1997 insert began: “The past year was a good one for State Farm Mutual and its policyholder group. [][] Because of improved claims experience, we were able to reduce auto insurance rates in more than half the states. ... [1] State Farm Mutual’s customers in 29 states and the District of Columbia received more than $651 million in policyholder dividends. The dividend reflects better-than-expected claims experience in those states. . . . [f] . . . [f] The funds available for the overall financial protection of State Farm Mutual’s 37 million policies in force increased last year, due significantly to favorable investment results.” Following the chairman’s message was a breakdown of State Farm’s assets and liabilities. The financial information and terminology on the insert were taken from the Audited Reports, prepared by Coopers & Lybrand in compliance with the accounting principles of the Illinois Department of Insurance.

2. Plaintiffs’ Evidence

In opposition to summary judgment, plaintiffs relied in part on State Farm’s evidence, drawing different inferences to support their own arguments. They submitted additional evidence in an effort to challenge the frequency and amount of State Farm’s dividends and the size of the surplus. Plaintiffs also offered evidence to show that the Board did not adequately consider whether to declare dividends and was not sufficiently informed to make dividend decisions. Last, plaintiffs asserted that State Farm misled policyholders about the use and size of the surplus.

The opposition papers contained several expert declarations, including one from a professor of corporate governance and one from an actuary. State Farm filed objections to both declarations. (As relevant, the specific evidence offered by plaintiffs will be described and discussed below.)

3. Trial Court’s Decision

On August 3, 2006, the trial court, Judge Carolyn B. Kuhl presiding, filed an order granting summary judgment and issued a 27-page opinion. The opinion discussed the business judgment rule and the evidence submitted by the parties. It concluded that State Farm had made a prima facie showing that it was entitled to summary judgment and that plaintiffs had failed to “offer evidence sufficient to establish an exception to the business judgment rule.” Further, the trial court sustained State Farm’s objections to the declaration of plaintiffs’ actuarial expert, finding it inadmissible because the declarant was not knowledgeable about mutual, as opposed to stock, companies.

Judgment was entered on August 18, 2006. Plaintiffs filed a motion for new trial, which was denied. They appealed.

II

DISCUSSION

Plaintiffs contend they had a right to dividends under their insurance policies and bylaws. State Farm counters that, as a matter of law, there was no promise to declare dividends, making this an open and shut case. It is not so simple. We conclude that plaintiffs did not have a right to any amount of dividends, but State Farm was obligated to consider from time to time whether dividends should be declared.

In considering whether to declare dividends, State Farm was bound by a duty of care, requiring the Board to make decisions in a prudent manner. According to plaintiffs, State Farm breached the duty of care by failing to act prudently in making dividend decisions. In response, State Farm invokes the business judgment rule. Plaintiffs argue that several exceptions to the rule apply. We reject plaintiffs’ argument.

First, plaintiffs correctly point out that the business judgment rule does not protect the Board if it makes no decision. Yet the Board does not have to decide every underlying issue related to dividends. Directors may resort to delegation and reliance on officers and employees for information and recommendations. Here, based on the financial reports and additional input received from others, the Board adequately considered whether to declare dividends. The Board’s deliberations complied with the business judgment rule.

Second, plaintiffs properly state that if directors do not become sufficiently informed to make an independent decision about dividends, the company is not protected by the business judgment rule. But this exception is inapplicable here because, through numerous financial reports, including actuarial data, and discussions among the officers and directors, the Board was sufficiently informed and acted independently.

Third, plaintiffs contend that the Board engaged in fraudulent and dishonest behavior in two respects: first, by not explaining its dividend practices in its insurance policies and bylaws; second, by providing policyholders with misleading information about the financial condition of the company. We disagree with the first contention because an insurer need not explain the specifics of its dividend practices, particularly where the board expressly retains discretion in the matter. The second contention is flawed because the information provided to the policyholders was taken from a report prepared by independent accountants in compliance with state regulatory principles of accounting. And in making these contentions, plaintiffs produced no evidence that the Board acted with improper motives.

Finally, plaintiffs argue that the Board’s decisions were without merit. This is not, however, an exception to the business judgment rule. Rather, the rule focuses on whether the process used to reach the decision was tainted by fraud, oppression, illegality, or the like. The very purpose of the rule is to preclude liability for a company’s mistakes, errors, and mere negligence. An exception that permitted consideration of the merits of a board’s decisions would swallow the rule.

A. Standard of Review

Summary judgment is appropriate if all the papers submitted show that there is no triable issue as to any material fact and that the moving party is entitled to judgment as a matter of law. (Code Civ. Proc., § 437c, subd. (c).)

“ ‘ “A defendant seeking summary judgment has met the burden of showing that a cause of action has no merit if that party has shown that one or more elements of the cause of action cannot be established [or that there is a complete defense to that cause of action]. . . . Once the defendant’s burden is met, the burden shifts to the plaintiff to show that a triable issue of fact exists as to that cause of action. ... In reviewing the propriety of a summary judgment, the appellate court independently reviews the record that was before the trial court. . . . We must determine whether the facts as shown by the parties give rise to a triable issue of material fact. ... In making this determination, the moving party’s affidavits are strictly construed while those of the opposing party are liberally construed.” . . . We accept as undisputed facts only those portions of the moving party’s evidence that are not contradicted by the opposing party’s evidence. ... In other words, the facts [set forth] in the evidence of the party opposing summary judgment and the reasonable inferences therefrom must be accepted as true.’ ” (Buxbaum v. Aetna Life & Casualty Co. (2002) 103 Cal.App.4th 434, 441 [126 Cal.Rptr.2d 682], italics added.)

“[The way in which] the parties moving for, and opposing, summary judgment may each carry their burden of persuasion and/or production depends on which [party] would bear what burden of proof at trial.” (Aguilar v. Atlantic Richfield Co. (2001) 25 Cal.4th 826, 851 [107 Cal.Rptr.2d 841, 24 P.3d 493].) The business judgment rule creates a presumption that the Board acted properly (State Farm II, supra, 114 Cal.App.4th at p. 450) and applies to both directors and officers (Selcke v. Bove (1994) 258 Ill.App.3d 932, 935-936 [196 Ill.Dec. 202, 205, 629 N.E.2d 747, 750]). The presumption is rebuttable and may be overcome by evidence supporting an exception to the rule. (State Farm II, at p. 450.) Although courts have stated that a plaintiff has a “stringent” or “heavy” task in defeating the business judgment rule (see, e.g., Panter v. Marshall Field & Co. (7th Cir. 1981) 646 F.2d 271, 297; State Farm II, supra, 114 Cal.App.4th at p. 451; In re Fleming Packaging Corp. (Bankr. C.D.Ill. 2007) 370 B.R. 11 A, 786), we do not regard such statements as imposing a heightened burden of proof but rather as a recognition of the rule’s practical success.

B. Plaintiffs’ Claim to Dividends

Plaintiffs contend (1) they had a contractual right to dividends under their policies and the bylaws, (2) State Farm breached the policies and bylaws by declaring inadequate dividends, and (3) the business judgment rule does not apply to breach of contract claims. State Farm argues that plaintiffs’ contract claim is without merit as a matter of law, and we need not decide if the business judgment rule applies. We conclude that neither of those positions is correct. Plaintiffs did not have a right to any amount of dividends, but State Farm did have a duty to make dividend decisions in a prudent manner. The business judgment rule is a defense to such a breach of duty claim. To the extent possible, we rely on Illinois law in reaching our conclusion. (See State Farm II, supra, 114 Cal.App.4th at pp. 442-449.) If, however, Illinois courts have not addressed a specific point or if the decisions of other courts are of assistance, we rely on principles from other jurisdictions.

“[T]he rights and interests of policyholders in the assets of a mutual . . . insurance company are contractual in nature and are measured by their policies and by the statutes, charter and by-laws, if any, which comprise the terms of their contracts . . . .” (Lubin v. Equitable Life Assur. Soc. (1945) 326 Ill.App. 358, 365 [61 N.E.2d 753, 756] (Lubin).) “ ‘Whatever rights a member of a mutual company has are delineated by the terms of the contract, and come from it alone. . . . [Here, the] plaintiff says he does not depend for his rights upon the policy .... If the plaintiff depends upon anything but his rights under the contract contained in the policy, he depends upon something that does not exist.’ ” (Id., 61 N.E.2d at p. 756, italics omitted.)

“[I]t is equally important to the policy-holders, as well as to the insurer, that definite and clear provisions . . . should be maintained unimpaired by loose or ill-considered interpretations. . . . The relation of an insurance company to its policy-holders is purely contractual. The parties here were competent to contract and had the right to insert such lawful provisions in the agreement as they saw fit. It is the duty of the courts to construe and enforce them as made, and not to make a new contract for the parties.” (Coons v. Home Life Ins. Co. (1938) 368 Ill. 231, 238 [13 N.E.2d 482, 485], citation omitted