The directors are subject to the fiduciary duties of loyalty and care. The bulk of this discussion will focus on the Delaware law, supplemented by the MBCA at the end.
Standards of Conduct v. Standards of Review
Standard of conduct (what directors are supposed to do – duties of loyalty and care) verses the standard of review (defines when directors are liable for their conduct). Standards of review include the business judgment rule and entire fairness, which may be excuses to poor conduct.
Business Judgment Rule
A presumption that the directors acted in good faith and were informed in making decisions for the company. To overcome the business judgment rule, the plaintiff must show “the decision was so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration.” In other words, to prove waste, the plaintiff must show that the majority of directors either (1) were interested, (2) lacked independence, (3) were not adequately informed, or (4) acted in bad faith.
Two parts: Fair dealing (timing, structure, negotiations, etc.) and fair price. This is a more difficult standard for the corporation to defend, but can be done.
- Majority of directors made a poor decision affecting a plaintiff.
- Plaintiff must overcome the business judgment rule by showing waste.
- Plaintiff must then overcome the principal of entire fairness.
- If successful, the plaintiff will have shown that there was a breach of the duty of care.
Duty of Care
When evaluating whether there was a breach of the standard of care, the courts will examine the corporations “decision making process” rather than the decision itself or the result. In other words, was the board adequately informed before they made their decision? To answer this question, the courts will look at what material the corporation had before them and whether there was gross negligence in neglecting that preparation. Gross negligence is defined as “reckless indifference to or a deliberate disregard of the boy of the stockholders’ or actions which are ‘without the bounds of reason.'”
Exculpation provisions say that directors are not directly liable for monetary damages for a breach of the duty of care. That is, if a plaintiff is suing for monetary damages, and the charter contains an exculpation provision, the court’s will not consider whether the directors were grossly negligent in being inadequately informed.
These provisions, however, do not protect the corporation from equitable relief. That is, the decision may be stopped by the court if the decision has not yet been implemented (e.g., closing on a merger).
Duty of Loyalty
Addresses the principal-agent problem; directors are required to act in the best interest of the corporation, not self-interest. Liability can be found in any of the following contexts.
Conflicting Interest Transactions
A transaction between a director and the corporation. However, these transactions are not voidable if (1) majority of disinterested directors approve, (2) majority of disinterested shareholders approve, or (3) the transaction is fair to the corporation. DGCL § 144. However, there may still be liability as a breach of the duty of loyalty. The analysis goes as follows.
- Director has to show it was fair. If so, no breach of loyalty. If not fair, has to pay for the damages (make it fair).
- The director can avoid showing fairness if it was approved in advance by a fully informed majority of either disinterested and independent directors or shareholders. At that point, the business judgement rule would apply.
Interested = the director receives a material economic benefit that makes it improbable that they will fulfill their duties without bias.
Independence = The decision was made without the influence or control of any interested parties.
Fully informed = Not only informed about the transaction, but of the nature of the conflict and any potential independence issues.
Failure to Act in Good Faith
Good faith is defined as “an intentional dereliction of duty, a conscious disregard for one’s responsibilities, and deliberate inaction in the face of a duty to act.”
Later, this definition was clarified to be applied as a subcategory of the duty of loyalty.
As part of the duty to act in good faith, directors are obligated to ensure that there is adequate oversight over the corporations affairs and failure to do so was a breach of good faith. These types of claims are difficult to bring and even more difficult to be successful.
Usurping Corporate Opportunities
When the director takes an opportunity that should have belonged to the corporation. The director cannot take the opportunity for themself if (1) the corporation can financially exploit the opportunity, (2) the opportunity is within the corporation’s line of business, (3) the corporation has an interest (or expected interest) in the opportunity, (4) by taking the opportunity, the director will by in conflict with the interests of the corporation.
If the opportunity does belong to the corporation, then the director needs to present the opportunity to the board as a safe harbor. Thus, if the corporation renounces that interest, the director is free to take the opportunity. DGCL § 122.
Best Interest Definition
In summary, the best interest of the company is to engage in activities directly designed to make a profit or save expenses for the entity.
Duty of Disclosure
This duty arises both under the duty of loyalty and care. It obligates directors to provide accurate and complete information related to transactions upon which they anticipate making a decision.
When the corporation is internally harmed, usually the harm is caused by the directors. However, since the directors often have the discretion to sue, they refrain from doing so. Thus, most lawsuits arising out of a breach of duty are derivative suits (actions brought by shareholders in behalf of the corporation when the directors refuse to do so).
For a derivative suit to be successful, the shareholder-plaintiff must first make a demand of the board of directors to pursue the claim or prove that such a demand is futile. A demand is futile if the majority of the board (1) received a material benefit, (2) faced a substantial likelihood of liability if the claim was brought, or (3) lacked independence from a board member subject to (1) or (2).
If the claim is futile, then the board is likely to appoint a special litigation committee with disinterested and independent board members. Their task is to investigate the claim and see if it is in the best interest of the corporation to pursue, settle, or dismiss the claim (most of the time, dismissal occurs). If the SLC determines that the case should be dismissed, the business judgment rule does not apply. In that case, the court will first evaluate the independence and disinterestedness in acting in good faith of the committee board members and second utilize its own business judgment to determine whether the case should continue.
Direct v. Derivative
To avoid the analysis above, the shareholder could claim that they were directly harmed from the decision (thus bringing a direct suit rather than a derivative one). In a direct claim, the shareholder would receive the benefits of any successful lawsuit, not the corporation.
Standards of Conduct
MBCA § 8.30: (a) act in good faith in the best interest of the corporation (loyalty) and (b) provide adequate oversight using a reasonableness standard (care).
§ 8.31: standard of liability (Delaware version is review): essentially the same as the business judgment rule. Overcoming the business judgment rule then moves to see whether there was harm done which was caused the director’s conduct.
Conflicting Interest Transactions
MBCA §§ 8.60-8.63: These essentially codified the process utilized by Delaware case law.
Usurping a Corporate Opportunity
MBCA § 8.70: Safe harbor rules.
Shareholder Derivative Suites
MBCA § 7.42: Same as Delaware except no demand requirement. In 7.42, the demand element is required (no futility exception), must be written and then the suit can be filed 90 days after the letter was sent.
Duties of Officers
Same duties as directors. These rules are established by case law in Delaware, MBCA § 8.42, and agency law. The main difference is that under the MBCA, only directors and not officers can have an exculpation provision (DGCL § 102(b)(7) allows certain officers to enjoy the provision).
Duties of Controlling Shareholders
Controlling shareholders owe a duty to the corporation and the other shareholders. A shareholder becomes controlling when they (1) own more than 50% of the voting power or (2) exercise control over the business affairs of the corporation, even if they have less than 50% of the voting power. Exercising control can be proved by the party’s position, decision making ability, filings, etc. This status can change from decision to decision, depending on the shareholder’s involvement.
Indemnification, Advancement, and Insurance
Even if the director loses, the company is likely to indemnify the director (mostly because all the directors will want to be indemnified if they ever face a similar situation). A corporation is required to indemnify if the director or officer is sued and wins. However, the corporation may voluntarily indemnify if they lose. During the litigation process, the corporation is also allowed to advance litigation expenses
The corporation can also purchase Director and Officer Insurance (D&O). Side A protects directors and officers when there is no indemnification available. Side B reimburses a corporation for the expenses made fulfilling indemnification obligations.
The content contained in this article may contain inaccuracies and is not intended to reflect the opinions, views, beliefs, or practices of any academic professor or publication. Instead, this content is a reflection on the author’s understanding of the law and legal practices.