What fiduciary duties does the board of directors have to the corporation?

Potential and sitting board members care about the scope of these duties as a corporate governance issue. Shareholders can sue directors for breach of fiduciary duties through a derivative action (and directly in certain instances) and hold them personally liable for damages to the corporation. For example, HP shareholders sued the board for breach of fiduciary duty when the board forced CEO Mark Hurd to resign.

Under the corporate law of most states, directors must discharge two primary fiduciary duties.

1. The duty of care
2. The duty of loyalty

The Duty of Care

The duty of care requires directors to make a business decision based on all available and material information and to act in a deliberate and informed manner (see Note 1 below). First, the board must act in good faith for the company's best interest. Second, they must believe that the actions promote the best interest of the company based on a reasonable investigation of the options available.

Courts apply the business judgment rule to determine whether the board has properly discharged the duty of care. In brief, the business judgement rule says if directors that acted in good faith and as a reasonable person would have acted, they will not be held liable for unfavorable outcomes. Accordingly, shareholders cannot hold the board liable for negative consequences of a bad decision that was reasonably made.

More recently, courts have clarified that gross negligence (e.g., failure of directors to properly inform themselves before making a decision), without more, does not constitute a breach of the duty of care (see Note 2). In reaching that conclusion, the court explicitly distinguished between the duty of care and the duty of good faith. Several statutes in Delaware law distinguish between the duty of care and the duty of good faith and, importantly, eliminate director liability for breaches of the duty of care, but not for breaches of the duty of good faith. In the court's view, any definition that makes a violation of the duty of care an automatic violation of the duty of good faith undercuts the legislative intent of these statutory protections.

The Duty of Loyalty

The duty of loyalty imposes on the board an affirmative duty to protect the interests of the corporation, and also an obligation to refrain from conduct which would injure the corporation and its shareholders (see Note 3). Directors must avoid any conflict between duty and self-interest. Undivided allegiance to the corporation's best interest is required.

Consistent with the view that the duty of care and the duty of good faith are different, the duty of good faith is a subset of the duty of loyalty. Board members must therefore refrain from self-dealing. Self-dealing occurs when one uses her position for personal profit at the expense of the company. For example, if the corporation enters into a closed bid contract with the director's company, and especially if the transaction is not publicly disclosed, that presents a potential situation of self-dealing and a breach of the duty of loyalty.

The business judgment rule will not help a director who breaches the duty of loyalty. Fraud, bad faith, and self-dealing nullify the good faith presumption of the business judgment rule (see Note 4). Because the duty of loyalty encompasses the failure to act in good faith, the duty is broader in scope than many directors realize:

“[T]he fiduciary duty of loyalty is not limited to cases involving a financial or other cognizable fiduciary conflict of interest. It also encompasses cases where the fiduciary fails to act in good faith...

Where directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith.” (see Note 5).

(emphasis added)

Conclusion

This post summarizes the two central fiduciary duties that directors have in most circumstances. These duties apply in private and public corporations, startups, global companies, and nonprofit organizations, with a few nuances. In specific situations, such as tender offers for mergers and acquisitions, closely held corporations or in going private transactions, the board is subject to additional standards of review and conduct.

Board members: What most concerns you about your fiduciary duties?

Douglas Y. Park
Twitter: @DougYPark

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Note 1. Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984).

Note 2. In re Walt Disney Co. Derivative Litigation, 906 A.2d 27, 53 (Del. Ch. 2006).

Note 3. Ivanhoe Partners v. Newmont Mining Corp., 535 A.2d 1334, 1345 (Del. 1987).

Note 4. Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 360 (Del. 1994).

Note 5. Bridgeport Holdings Inc. Liquidating Trust v. Boyer (In re Bridgeport Holdings, Inc.), 388 B.R. 548, 564 (Bankr. D. Del. 2008) (quoting Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006)).