Standards Governing Actions of Corporate Directors - Explained
Director Duties of Care and Loyalty
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Table of ContentsWhat standards govern the actions and decisions of the board of directors?What is a Directors' Duty of Care?What is a Director's Duty of Loyalty?How Should Directors Handle a Corporate Opportunity?Discussion QuestionPractice QuestionAcademic Research
What standards govern the actions and decisions of the board of directors?
Aside from requirements stated in the articles of incorporation, bylaws, and detailed governance provisions laid out in the previously-referenced laws, boards of directors owe fiduciary duties to the corporation. Fiduciary duties include a duty to act in good faith in all actions, a duty of loyalty, and a duty of care.
Next Article: What is the Business Judgment Rule Back to: Corporate Governance
What is a Directors' Duty of Care?
Directors owe a duty of care to the corporation. The duty of care requires officers and directors to act in the best interests of the corporation and to use the same care that an ordinarily prudent person would exercise in a similar situation. This standard is similar to a negligence standard in tort cases. The duty of care requires that directors make decisions in line with three principles:
Legality- Generally, decisions by directors that violate the law also breach a duty of care to the corporation.
- Note: This is true even if the illegal action is taken for the benefit of the corporation.
Rational Business Purpose- Directors must make decisions, particularly those committing resources of the corporation, based upon a rational business purpose. Most courts assume that decisions made by directors are based upon a rational business purpose.
- Note: This is a very low standard, as any action could constitute a rational purpose.
- Informed Decision Making - Managers must take reasonable steps to research or seek information about a situation before making a decision or taking action. An informed decision that harms the company will generally not result in liability for the director if not done recklessly or with the intention of harming the corporation.
What is a Director's Duty of Loyalty?
Managers have an obligation to act in the best interest of the corporation and without personal conflict of interest. More specifically, directors cannot take actions or make decisions that benefit themselves at the expense of the corporation. The duty of loyalty protects against self-dealing and usurping of corporate opportunities by directors.
- Self-Dealing - If a director engages in self-dealing, she may be liable to the corporation for damages resulting from the action. The business judgment rule does not protect directors from liability for self-serving actions; however, corporate law does not entirely prohibit self-serving transactions. The court is charged with determining whether a transaction constitutes self-dealing and should lead to liability for the director. An affirmative answer to any of the following inquiries may avoid director liability for an otherwise inappropriate transaction:
Director Approval- Was the directors action reviewed and approved by a majority of independent directors?
- Note: An approval vote from disinterested directors makes it more likely to not constitute self dealing, but it is not determinative.
Shareholder Approval- Did the disinterested shareholders approve it?
- Note: If the transaction is approved by a majority of disinterested shareholders, it will not be considered self dealing. The reasoning is that shareholders are those sought to be protected. Shareholders can vote to approve transactions that limit their own benefits?
Fairness- Is the transaction fair to the corporation? That is, the corporation must not lose or forgo a right or benefit at the expense of the directors action. The court will look to determine whether the value provided to the corporation was reasonable in comparison to the value gained by the directors.
- Example: I am director of ABC Corp. The board is in search of land to construct a new manufacturing facility. I purchase a parcel of land that would work perfectly and immediately sell it to the corporation for a huge profit. Several members of the board approved the transaction, but the board did not submit it for shareholder approval. This is obviously a self-serving transaction. If the transaction is later challenged by shareholders, the court will closely evaluate whether the purchase price and other terms of service were fair to the corporation.
- Corporate Opportunity - The corporate opportunity doctrine prohibits officers, directors, and controlling shareholders from excluding their company from favorable deals. This generally means that directors cannot compete with the corporation. Competing means providing a good or service that the corporation provides. Competing with the corporation may also include providing a good or service to a prospective customer or client of the corporation where the client originally approached the corporation for that good or service.
How Should Directors Handle a Corporate Opportunity?
A Director may avoid liability to the corporation by showing:
- Offer to Corporation - The director offered any opportunity to the corporation and a majority of disinterested directors or shareholders agreed to turn down or not pursue the opportunity; or
- Not a Corporate Opportunity - The alleged opportunity was either not an opportunity at all or the corporation generally had no right or claim to it.
Example: I am a director of ABC Corporation. ABC provides tax and auditing services to clients. If a current client approaches the corporation about payroll services, I cannot provide those services to the client personally without offering it to the corporation. It would equally be a violation of my duty of loyalty if I personally offer tax and auditing services to the public while sitting on ABC's board.
Overview of Board of Directors
- What is the role of the Board of Directors?
What is the composition of the board of directors?
- What is the Business Judgment Rule?
- What is D&O insurance?
- Codetermination (Foreign)
- Duty of Candor Definition
- Duty of Care (Board of Directors)
- Duty of Loyalty (Directors)
- Board Evaluation Definition
How do you feel about a directors duty of care? Should the standard of care owed to the corporation be higher or lower? Why? How do you feel about the directors duty of loyalty? Should self-interested transactions by directors be allowed? Why or why not? Does the limitation on usurping corporate opportunities go too far in limiting the abilities of directors or should it be more protective of the corporation? Why?
Winston is a director of ABC Corp. He is also the president of a local mortgage company. As a director of ABC Corp, Winston is a member of as special committee that makes recommendations for corporate investments. Specifically, he helps evaluate certain classes of investment for the corporation to purchase. He recommends the corporation purchase collateralized loan obligations as safe, high-yielding investments. His mortgage company sells the corporation several million dollars in bundled, collateralized loans. The corporation pays a premium for the loans because the underlying mortgages are all local. Later, the housing market crashes and ABC Corp loses lots of money. What are potential grounds for Winston's liability to the corporation?