What are the fiduciary duties of directors in a corporation?

Fiduciary duties are a set of duties that officers, directors, and shareholders owe to the corporation. Because those who own the company are not necessarily the ones in direct control of the corporation, those who are in control owe several duties to the owners. These duties are intended to ensure that those in control of the corporation act in the best interests of the shareholders. In other words, shareholders are the primary beneficiaries of the duty of care.  There are a few exceptions to this norm for corporations for non-profits, charities, and benefit corporations, when other interests must be factored in as well.

The Business Judgment Rule states that courts will presume that in making a decision the board acted:

  • With an informed process (duty of care);
  • In good faith (duty of good faith- incorporated into duty of loyalty); AND
  • With the honest belief that its actions are in the best interests of the corporation (duty of loyalty).

The basis behind the business judgment rule is that courts should not be telling businesses how to make decisions because they have the benefit of hindsight. Further, directors have to take some risks and they cannot be personally liable for every risk that they take.

Duty of Care:

Now let’s look closer at the duty of care. The court will generally presume in the making of a decision the board acted with informed process. They will look to the process and try to determine if it was grossly negligent. The process of a duty of care claim is as follows:

Can plaintiffs rebut the court’s presumption? In some circumstances, yes.  If they do, the burden shifts to the board to prove that a majority of fully informed, independent shareholders approved the transaction, or that the decision was entirely fair to the corporation.  If they cannot the shareholder (plaintiff) can only win by proving the decision amounted to waste. This is a much more difficult task.

The previously mentioned “safe harbor” statute comes into play with the duty of care because the directors are protected from liability if they relied in good faith on the corporation’s records or reports from officers or employees. Further, the directors are protected if they relied in good faith on experts as long as the director reasonably believes that the matter is within the expert’s professional competence and the expert was selected with reasonable care. Additionally, directors can be protected from duty of care claims through exculpation. Exculpation clauses state that the corporation or shareholders cannot bring monetary claims against a director for a duty of care claim. Lastly, the company may choose to include an indemnification provision where they company pays damages rather than the director. Indemnification can be provided for not only directors but also officers, employees and agents. However, it only applies if the defendant acted in good faith and in a manner reasonably believed to be in the best interests of the company.

Duty of Good Faith:

To show a breach of duty of good faith the directors must have utterly failed to implement any reporting or information system or controls, OR consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.  Further stated, if the directors know of a risk they cannot consciously disregard this risk. Courts have stated that this is the most difficult theory in corporate law in which a plaintiff might hope to win a judgment. Additionally, exculpation and indemnification clauses do not provide protection when good faith has not been demonstrated.

Duty of Loyalty:

The duty of loyalty is relatively straight forward; directors must put the corporation’s interests ahead of their own when it comes to transactions where there may be a conflict of interest. In any situation where a potential conflict of interest exists it is very important to take certain steps to avoid the transaction becoming void or voidable. A conflict of interest transaction is one where the transaction involves a potentially majority/controlling shareholder or a director or officer on both sides of the transaction, such as a director’s side-business contracting to supply goods or services to the corporation. If the transaction involves a shareholder who does not hold a controlling interest in the corporation, then there is no conflict of interest issue present.

A majority shareholder is someone who owns 50% of the total corporation. A controlling shareholder can be a little more challenging to determine. As a rule of thumb, if the shareholder has over 40% of the total corporation they will be found to be controlling. Below 20% of the corporation is rarely found to be controlling. Lastly, the space between 20%-40% is unclear and could go both ways depending on the case specific facts.

If you know you are facing a potential conflict of interest transaction, you can still go ahead with the deal, provided you obtain the proper consent from the corporation. If a majority of independent, fully informed shareholders or directors that approve the transaction you’re in business. The cleansing vote drastically alters the standard that the court applies when reviewing the transaction if a dispute were to arise. If there has been a cleansing vote the business judgment rule applies (this is a good thing!). However, if there has not been a cleansing vote, then the entire fairness standard applies with the burden on the defendant to prove the transaction was “entirely fair.”

The entire fairness standard is significantly more difficult to satisfy as compare to the business judgment rule. This standard requires a demonstration of a fair price and fair dealing. When dealing with a controlling shareholder (as opposed to directors/officers), even with a cleansing vote the entire fairness standard applies; however, a cleansing vote shifts which party carries the burden of proof! If there has been a cleansing vote, then the plaintiff has the burden to prove the transaction was not entirely fair. If there was no cleansing vote, then the burden falls back on the defendant to prove entire fairness.

The bottom line here is that in this situation it is not better to ask forgiveness than to seek permission: make sure your transaction has an independent group of people that are able to provide the transaction with the required approval!

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© 2016 John V. Robinson, P.C.