United States: Duties Of Corporate Directors

It is no longer a rare occurrence today for a director of a corporation to find him/herself a defendant in a lawsuit. Likely claimants against a director would include (i) a shareholder suing on behalf of the shareholder and all other similarly situated shareholders, (ii) the corporation itself, (iii) a shareholder bringing an action on behalf of the corporation or (iv) a representative, such as a trustee in bankruptcy or a receiver, suing on behalf of the corporation. The focus of this article is on the duties of directors. The duties of directors arise out of the corporate law of the state of incorporation and federal and other state laws directed to certain specific conduct of the director, such as the federal and state securities laws, environmental laws and, for the financial industry, The Financial Institutions Reform Recovery and Enforcement Act (FIRREA).

The state corporate law generally provides that the business and affairs of the corporation shall be managed by or under the direction of the board of directors. In the exercise of these powers the directors have a duty of care and a duty of loyalty.

The duty of care requires the director to act in accordance with applicable standards in fulfilling his/her obligations as a director. The Georgia, Tennessee and Delaware statutes and judicial decisions require a director to discharge his/her duties with the care an ordinarily prudent person in a like position would exercise under similar circumstances. If the director’s action meets this standard, the director has performed his/her duties with the requisite due care and can not be held liable for any loss to the corporation resulting from the director’s action or inaction. It is the failure to meet this standard that can result in liability to the director.

The standard of care may not be the same for each director. It can be altered by the expertise that the director possesses. Often directors are selected for the experience and background that they bring to the board and its deliberations. The special background, qualifications and experiences of a particular director may be relevant in evaluating his/her compliance with the standard of care required. For example an attorney serving on the board of directors would be expected to bring to the board’s attention any action that was illegal which he/she should have been aware of in view of the nature of his/her legal experience. However, the other directors who were not attorneys would not be expected to be as vigilant with respect to legal matters. Another example would be an accountant or financial executive serving on the board of directors, he/she may be expected to notice financial inconsistencies, adverse financial trends and other financial issues that may be material to the operation of the corporation that a director who does not have a financial background would not notice. Also inside directors are expected to have greater knowledge of the business and affairs of the corporation, and therefore be in a position to identify situations of concern at an earlier date and to recommend corrective action.

In the exercise of due care by a director, he/she may rely upon financial statements, reports, opinions and statements of the executives of the corporation, legal counsel, public accountants and other experts (which the director reasonably believes to be reliable and competent).

The duty of care requires directors to maintain adequate oversight of corporate operations and to obtain adequate and reliable information before making decisions. A director’s duty of care encompasses a duty to oversee or monitor the corporation’s activities. At a minimum a director should regularly attend board meetings, carefully review all documents presented to the Board, review and inquire as to the corporation’s financial statements, inquire as to the corporation’s major activities and monitor the performance of the key officers, such as the chief executive officer, chief operating officer and the chief financial officer. Directors can not leave it up to the chief executive officer as to what information is presented to the board but must require the furnishing of that information which is necessary to oversee and monitor the corporation’s activities. The directors are not charged with the responsibility for the day to day operations of the business of the corporation. Their job is to oversee those activities. Thus, in the exercise of due care, directors must constantly seek that information which is necessary to fulfill their responsibilities.

In making decisions, there is no breach of their duty of care if the decision by hindsight turns out to be imprudent. However, before making decisions they must obtain the relevant facts, where appropriate, obtain opinions from experts and, most importantly, carefully consider all of the evidence and opinions that are presented to them before they make a decision.

The duty of care of directors of a corporation that have received an offer to purchase the corporation under the state’s corporate laws is complex and is not the subject of this article. It is suggested that those issues are best discussed with your corporate counsel.

Some state corporate law statutes specifically permit the limiting or eliminating of liability for monetary damages of directors under certain circumstances, even in the absence of due care. For example, the Georgia corporate laws permit the inclusion in the articles of incorporation a provision eliminating directors liability for monetary damages for breach of the duty of care unless the liability arose out of a misappropriation of a corporate opportunity, intentional misconduct, knowing violation of the law, or a transaction in which the director received an improper personal benefit. Tennessee has a similar provisions. Delaware is silent in this area.

Certain federal and state statutes set forth a standard of conduct of directors applicable only to the matters addressed in the statute. Such statutory standard would supersede the standard contained in the state corporation law. The most notable example is the standard of care for directors contained in the federal securities laws, e.g. Securities Act of 1933 ("1933 Act"). For example, directors have liability in the event the registration statement filed by the corporation with the SEC in connection with the public sale of securities contains an untrue statement of material fact or omits a statement of material fact necessary in order to make the statements, in light of the circumstances under which they were made, not misleading. However, the 1933 Act further provides that a director shall not be liable if the director sustains the burden of proving that the director had, after reasonable investigation, reasonable grounds to believe and did believe that the statements contained in the registration statement were true and that there were no omissions to state a material fact required to be stated therein. Under the 1933 Act the duty of care is to make a reasonable investigation and reasonably believe that there were no material misstatements or omissions. This duty is undertaken in part by the appointment of competent experts to prepare the registration statement, including counsel, public accountants and underwriters. It does not, however, allow the director after appointing such persons, the luxury of not reading carefully the registration statement and making appropriate inquiries regarding its contents and omissions and, if appropriate, suggesting modifications.

FIRREA is another example of a federal statute that defines the standard of due care. It establishes the duty of care for directors of financial institutions insured by the FDIC. FIRREA requires a finding of gross negligence or intentional tortious conduct by the director before liability may be imposed.

Each director has a duty of loyalty to the corporation. That is, the director must act in the best interest of the corporation and not in the best interest of the director, his family or any entity or person with which he/she is affiliated. The Tennessee and the Georgia corporation codes require directors to carry out their duties in good faith and in a manner in which he/she believes to be in the best interest of the corporation. The Delaware code does not have a comparable provision; however, such duty has long been recognized in Delaware by judicial decisions.

The duty of loyalty often arises in connection with the execution of contracts with the director or his/her family or entities which are affiliated with the director or members of his/her family. If there has not been full disclosure of the conflict of interest and the contract is not approved by a majority of disinterested directors or shareholders, there may be a breach of the duty of loyalty if the contract is not fair to the corporation.

Another example of a breach of the duty of loyalty is the misappropriation of a corporate opportunity. If a business opportunity arose (e.g. an acquisition of land) in which the corporation of which he/she is a director would have an interest in pursuing, and the director took personal advantage of the opportunity and did not make the business opportunity available to the corporation, the director breached his/her duty of loyalty. If a director is aware of a potential acquisition of a business, for example, that would be beneficial to the corporation, and participates in the acquisition other than through the corporation, the director may have violated his/her duty of loyalty. The director should have brought the potential acquisition to the attention of the corporation, and only if the corporation decided not to pursue the acquisition could such director participate in the acquisition by another entity. In such cases the director also should make known his/her interest in the proposed transaction.

The duty of loyalty usually requires full disclosure of any conflict of interest and that the action be approved by a disinterested board or by the shareholders. If such conflicts arise, normally the director is not required to resign, but is required to disclose his/her interest, abstain from voting on the matter and not participate in the deliberations.

Directors duties of care and loyalty are not to be taken lightly. Directors must be vigilant to ensure that they are fully informed as to the condition and prospects of the business of the corporation at all times. In light of the potential liability of a director and the complexity of the law, it is recommended that legal advise be sought when a director has any concern regarding his/her duties.

This article is not intended to provide legal advice on such a complex subject but to alert directors of their basic duties. While this article does not address the duties of officers, they have duties similar to those of the directors.