Monday, November 26, 2012

Duty of Loyalty of Corporate Directors

Directors of a corporation, whether it is a Delaware or a New York corporation or a corporation formed in another state, have certain duties towards their corporation and its stockholders. These duties are called fiduciary duties and they comprise of a duty of care and a duty of loyalty. Several courts also include the duty of good faith and fair dealing, while others treat it as a subset of the duty of loyalty.

Generally, so long as directors comply with their fiduciary duties, their decisions are protected by the business judgment rule, which assumes that directors have acted on an informed basis, in good faith and in the best interests of the corporation. When the business judgment rule applies, the courts will not second-guess the decisions made by directors and will not hold them personally liable even if the decision turned out to be the wrong one.

There are situations when the business judgment rule does not apply, and the courts analyze the Board decisions with greater scrutiny. Typically, this happens in cases of the company sale, or if the approval of a transaction was made by interested directors, or if the company adopted defensive tactics that were not proportionate to the threat posed to it.

Today, I want to focus on the duty of loyalty (remember, the business judgment rule will not protect a director who breaches the duty of loyalty). The duty of loyalty requires directors to act in good faith and in the best interests of the corporation, and put the corporation’s interests above their personal interests. This also means that directors must abstain from any conduct that would harm the corporation. The subset of duty of loyalty is the duty of good faith and fair dealing that requires that directors “act at all times with an honesty of purpose and in the best interest and welfare of the corporation.”

The duty of loyalty prohibits self-dealing and taking of corporate opportunities by directors unless the disinterested directors agree to it. Most often, the breach of duty of loyalty may occur when there is:
  • a conflict of interest (a director has an interest in the opportunity presented to the corporation); 
  • taking of a corporate opportunity (using the opportunity that should have been presented to the corporation); 
  • competing with the corporation (without disclosing it); 
  • misappropriating corporate assets (using corporate assets for non-business purposes); 
  • egregious conduct (acting in bad faith).  
Just recently, on October 1, 2012, the Delaware Court of Chancery held that a director violated his duty of loyalty to the corporation because through his actions he consciously harmed the corporation. (Shocking Technologies, Inc. v. Michael, et al., C.A. No. 7164-VCN (Del. Ch. Oct. 1, 2012)). In this case, Shocking Technologies, Inc. sued Simon Michael, its director, because Michael tried to dissuade the company’s only potential investor from investing in the company. Michael also shared confidential company information with that same investor. In particular, Michael used the company’s dire need for financing to coerce other directors into meeting the investor’s demands, while at the same time coaching the investor not to agree to invest unless it received better terms, including a board seat. Importantly, Michael disclosed to the potential investor that it was the only potential investor at that time, which negatively affected the company’s bargaining position. The Court held that Michael breached the duty of loyalty because he was not acting in the best interests of the corporation (which was to obtain short-term financing), and actually his disclosure of confidential information was to the company’s detriment. The full opinion is available here:

Directors of all companies, whether public or private, should regard the duty of loyalty very seriously. In Delaware, unlike the duty of care, liability for breaching the duty of loyalty cannot be contractually limited, and directors may not be indemnified for breaches of duty of loyalty involving bad faith. In the next blog posts, I would like to take a closer look at the duty of care as well as the question of when the corporation’s corporate veil (i.e., limited liability) can be pierced.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

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