When bringing on new board members or officers, companies should make sure those individuals are aware of their responsibilities to the company. This includes their “fiduciary duties” to the company.
Why do corporate board members and officers owe fiduciary duties, and which duties are owed?
Shareholders are the owners of a company. The success of their investment hinges upon the success of the corporation. Yet, shareholders are not the ones who manage business affairs of the corporation. Instead, shareholders elect directors to manage major decisions and strategies for the corporation. In turn, the directors appoint officers to manage the day-to-day operations and carry out any resolutions made by the directors.
Directors act as agents of the shareholders, therefore they are charged with fiduciary duties to protect the best interests of the corporation as well as the shareholders. Since officers are appointed by directors, officers owe the same fiduciary duties to the corporation and shareholders as the directors.
The two major fiduciary duties are the duty of care and the duty of loyalty.
The duty of care: informed and careful action.
The duty of care requires a director to be fully and adequately informed and to act with care when making decisions. The amount of care required is typically described as that of an ordinarily careful and prudent person in similar circumstances. This duty extends to lack of action as well. If there is a situation where a careful person would have taken action, a director can breach the duty of care by failing to act. Generally, the director’s decisions will be scrutinized based on whether it was reasonable or not.
However, the duty of care does not require directors to take specific action. For example, directors do not have a duty to maximize the profits of the corporation. They may take actions that do not directly increase corporation profits, as long as there is a connection to a rational business purpose for the action.
Under Delaware law, for example, officers owe the same duty of care to the corporation and its shareholders. However, the consequences for breach are different. Namely, § 102(b)(7) of Delaware’s General Corporation Law only exculpates directors for breach of the duty of care, not officers.
The duty of loyalty: avoid self-dealing.
The duty of loyalty requires a director or officer to act and make decisions in the best interest of the corporation, rather than in their own personal interest. This duty requires directors to act in good faith for the benefit of the corporation, including both an affirmative duty to protect the interests of the corporation, but also to refrain from conduct that would harm the corporation or its shareholders.
Generally, breaches of the duty of loyalty are easier to spot. Breaches of the duty of care usually involve a director or officer acting in bad faith (i.e., self-dealing and competing directly with the company).
For example, a director (or officer) breaches the duty of loyalty when they usurp an opportunity presented to, or otherwise rightfully belonging to, the corporation. This is known as the corporate opportunity doctrine.
Delaware law looks at the following factors in determining whether a corporate opportunity has been usurped: whether the opportunity is in the same line of business as the corporation; whether the corporation has an interest or expectancy in the opportunity; whether the corporation would be financially able to take the opportunity as presented; and whether taking the opportunity would create a conflict of interest or be a breach of a fiduciary duty of the individual.
As shorthand, directors and officers should be wary of any situation where a conflict of interest exists: whether the director or officer is acting in their own self-interest adverse to the shareholders’ interest or in the interest of an interested third party from whom the director or officer is not independent.
Business Judgment Rule
As discussed above, directors’ decisions are scrutinized for their reasonableness. However, Delaware courts have recognized that sometimes directors must take business risks to promote the interests of the corporation and its shareholders, and that judges are not in the best position to second-guess these decisions that seem wrong in hindsight.
Enter: the business judgment rule. This rule presumes that directors act in the best interests of the corporation and its shareholders, and courts will not impose liability unless the director was grossly negligent.
Be aware, however, that issues involving a breach of the duty of loyalty, such as a conflict of interest, are not protected by the business judgment rule. A court will not presume that the director or officer acted in the best interest of the corporation when it comes to a breach of the duty of loyalty.
A note on jurisdiction:
Different states have different fiduciary duty laws and they apply in specific ways based on the court’s application of those laws in those states historically. Different countries also impose different duties. This post is meant only to provide a general overview of some common concepts.
