Fiduciary Duties of Directors and Principals: Are Your Decisions Protected from Attack?

October 22, 2009

This article is intended to provide a brief overview of some of the issues raised in a claim against the directors and principals of a business entity. With the current economic environment, now more than ever it is important for directors and principals of corporations and other business entities to understand what their responsibilities are to the entity, and what action needs to be taken in the decision making process. Indeed, a failure to make the necessary inquiries and exercise the proper care may result in a lawsuit from other principals, and in some cases, creditors, where personal liability could be imposed and easily bankrupt a director or principal. Generally, courts presume that a board of directors’ decisions are proper and in the best interest of the corporation, unless an individual challenging those decisions can show a breach of the board’s fiduciary duties of care, loyalty, and good faith. A director’s actions are analyzed under the “Business Judgment Rule.” Under this rule, there is a rebuttable presumption that good faith decisions based upon the informed, reasonable business knowledge by the board are not actionable by those who have an interest in the corporation, such as a shareholder. Essentially, the rule protects the board members from being questioned or second guessed by those with the benefit of 20/20 hindsight, except in instances involving fraud, self dealing, or unconscionable conduct. The rule places an initial burden on those challenging a corporate decision to demonstrate the improper circumstances. If so demonstrated, the burden then shifts to the board members to show that the transaction was fair to the corporation. If the presumption of the rule is not rebutted, the burden is on the objecting shareholder to demonstrate that no person of ordinary, sound business judgment would believe that the consideration was a fair exchange for the value given. Inherent in the rule is that the directors based their decisions on adequate information. In other words, the directors must take appropriate steps to ensure that they have sufficient information that is material to the issue at hand so they can make an informed decision. In addition to a duty of care, a director also owes the corporation a duty of loyalty. This duty requires that the director be disinterested and independent so that the director may act in the best interest of the corporation. A director generally is disinterested and independent if he or she is not acting in self interest or the interest of another to whom the director may be beholden. Examples of a lack of independence include circumstances where a director is acting in self interest (he will receive some personal financial or other benefit that others, such as the corporation’s shareholders, may not receive), when he has a competing interest to that of the corporation in connection with the decision to be made, or when he has a financial or personal relationship with another so the director cannot reasonably be able to act in the best interests of the corporation. The requirement that the director act in good faith may be the most difficult to determine. It is often used by plaintiffs to show that a director’s motives were other than in the best interest of the corporation, but not financially motivated. A plaintiff seeking to attack the decision of the board will likely name the board members as individual defendants in seeking damages. Moreover, generally speaking, principals of a closely held business, whether they are directors, officers, members, or partners owe, among other things, a fiduciary duty to the other principals. Thus, the stockholders in a closely held corporation owe each other substantially the same fiduciary duty of good faith and loyalty as that owed by partners in a partnership or directors in a corporation. The relationship has been characterized as one of trust and confidence, calling for the utmost good faith. The type of fiduciary duties discussed above will generally apply. There are many aspects to a claim, and this article is not intended to cover all aspects, or cover those issues discussed in depth. It does, however, touch upon some of the issues and provides a starting point for directors and principals to consider when taking corporate action. For more information, please contact Keith A. Krauss. This alert is provided for educational and informational purposes only and is not intended and should not be construed as legal advice. It is recommended that readers not rely on this publication but that professional advice be sought for individual matters.