Sunday, December 9, 2012

Examining Duty of Care of Corporate Directors

In addition to the duty of loyalty that corporate directors owe to the corporation and its shareholders, the directors also owe the duty of care.  As I mentioned in my earlier post, the duties of loyalty and care are the so called “fiduciary duties”.  Judges will respect the decisions of the directors (even if they turned out to be wrong) if the directors acted on an informed basis, in good faith and in the best interests of the corporation. This is called the "business judgment rule". Pursuant to it, courts will not question the directors’ decisions unless they have breached their fiduciary duties: a duty of loyalty or a duty of care.

Duty of care can be summarized as requiring the directors to make informed decisions and consider carefully all of the available information before arriving at a decision. This seems like an obvious thing to do, but you would be surprised to learn how often this requirement is disregarded. In particular, directors should:
  • Obtain all relevant information 
  • Have sufficient time to consider such information 
  • Hire experts if necessary (accountants, lawyers, financial experts) 
  • Understand the terms of the proposed transactions, understand the corporation’s finances and closely monitor the performance of executive officers 
  • Institute and supervise a set of policies that would ensure the corporation’s compliance with applicable laws and regulations. 
Typically, directors will not be found liable if they simply failed to follow the best practices. Courts will find a breach of fiduciary duty of care only in cases where directors engage in gross negligence or act with reckless disregard for the shareholders’ interests.

For example, in Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), the court found that the directors breached their duty of care because (1) they did not know prior to the board meeting that there was a pending merger and that the deadline was the next day, (2) they approved the merger in a 2-hour meeting without even reviewing the merger agreement or questioning the purchase price, (3) they relied on the CEO’s oral report without questioning the CEO’s role in bringing the merger about and did not know that he had suggested the purchase price to the buyer. In another case, In re Abbott Labs Derivative Shareholders Litigation, the court found that the directors breached their duty of care because the FDA repeatedly over a period of six years served safety violations notices to the corporation, the directors knew about this, and took no steps to ensure that the corporation changed its practices.

Directors are not the only persons with fiduciary duties. Executive officers also owe fiduciary duties to the corporation and its shareholders. Additionally, controlling shareholders owe the duty of loyalty to the minority shareholders. The activities (such as a vote) by the controlling shareholders will be respected by the Delaware courts as long as their activities had a rational business aim and the controlling shareholders were not involved in “self-dealing”.

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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