The Duty of Care in corporate Governance

Question 1

As a recap, what are the duties of a fiduciary (trustee, partners, corporate director, or officer)?

Answer 1

1) Duty of obedience
2) Duty of care
3) Duty of loyalty

Question 2

What is the common definition of the duty of care?

Answer 2

A director has a duty to the corporation to perform the functions in

1) Good faith
2) In a manner that he or she reasonably believes to be in the best interests of the corporation, and
3) with care that an ordinary prudent person would exercise in a like position under similar circumstances.

Not as important as BJR, but important to know the difference.

Question 3

What is the most important prong of the duty of care

Answer 3

Duty to perform functions: with the care and ordinarily prudent person would exercise in a like position under similar circumstances.

Question 4

Is the duty of care presumed to be satisfied if the three conditions of the business judgment rule are satisfied?

Answer 4

Yes.

Question 5

What are the three conditions of the business judgment rule? According to the American Law Institute 4.01(c)

Answer 5

The director fulfill his duty of care if he is:

1) Not interests in the subject of the business judgment (like, personally)
2) is informed with respect to the subject
3) rationally believes that the business judgment is in the best interests of the corporation.

Question 6

What is the most important condition for the business judgment rule

Answer 6

The most important condition is that he is informed with respect to the subject. See Van Gorkom.

Question 7

What are reasons for having the business judgment rule? (4)

Answer 7

1) Encourages valuable risk taking. (reduces manager’s personal risk and reduces the incidence of meritless litigation)
2) Encourages people to serve on the board of directors (people with expertise are not concerned with being personally liable)
3) Directors are better positioned to decide (they are usually experts)
4) Reduces the cost of judicial intervention

Question 8

What are the key liability shields in Delaware?

Answer 8

1) Business judgment rule (most basis, if conditions were met then we can assume that the duty of care was met.)
2) Waiver of liability (corp can eliminate directors liability for duty of care violations)
3) Indemnification (corp may indemnify D&O if their actions were in good faith)
4) D&O insurance (corps may buy liability insurance whether or not they had the power to indemnify)
5) Reimbursement of legal expenses

Question 9

If there is evidence of self-dealing, will the BJR apply?

Answer 9

No, that means the directors were interested.

Question 10

If a small amount of the board, say 4 out of 24 were interested in the decision, does that make the entire board interested?

Answer 10

No, it does not necessarily mean that. Every action taken by the board may have some personal impact.

Question 11

Will negligence of the directors mean that they were uniformed?

Answer 11

No, they must be grossly negligent.

Question 12

What is an example of directors behaving grossly negligent?

Answer 12

Meeting for 90 minutes to discuss an important deal and not even reading the agreement. ( Van Gorkom)

Question 13

Why is there a higher standard in takeover cases? I.e., why are they scrutinized more?

Answer 13

There is more risk in takeovers.

Question 14

What is the difference between being uniformed, negligent, and grossly negligent?

Answer 14

Careful consideration is the key. Just because you made a bad decision doesn’t mean you were grossly negligent.

Question 15

Do we focus on the process or the outcome when reviewing business judgments?

Answer 15

The process. Even if the outcome is good.

Question 16

Is the BJR set in stone?

Answer 16

No, the courts continue to refine it.

Question 17

How do the duty of care and business judgment rule interact?

Answer 17

Well, in order to determine if the standard of care was met, courts will use the business judgment rule.

Remember, they are looking for gross negligence as opposed to regular negligence.

Question 18

What happens if a director is found to be interested in a BJR application?

Answer 18

Then the standard of judicial review will switch the entire fairness review (duty of loyalty)

Question 19

How can a director be considered informed?

Answer 19

Did he review all material information?

Question 20

Is the BJR rebutted if there is gross negligence in being informed?

Answer 20

Yes.

Question 21

If there is a liability waiver under 102(b)(7), what will a plaintiff need to prove in order to show that the director was not informed?

Answer 21

He will need to show bad faith.

Question 22

How does a plaintiff show that the transaction of director was no rational?

Answer 22

In practice, the plaintiff will be alleging waste.

There must be evidence that the transaction was so irrational, so poor, that it is unlikely the director was acting in the best interests of the company.

Question 23

What is “waste”?

Answer 23

An exchange of corporate assets for consideration so unreasonably small as to lie beyond the range at which any reasonable person would pay. (Brehm)

Question 24

Under DGCL 102(b)(7), firms are allowed to waive liability for breach of the duty of care unless…

Answer 24

there is bad faith.

Question 25

Will a director be held liable for breaching the duty of care (with respect to being informed, etc.) if there is bad faith.

Answer 25

Yes, doctrinally, it is worse than gross negligence.

Question 26

What is bad faith?

Answer 26

1) . Where the fiduciary INTENTIONALLY acts with a purpose other than advancing the best interests of the corporation.
2) Where the fiduciary acts with intent to violate positive law; or
3) where the fiduciary intentionally fails to act in the face of a known duty.

(Disney)

Question 27

What is the interaction of these four standards with the BJR:

1) Ordinarily prudent person
2) Gross negligence
3) Waste
4) Bad Faith

Answer 27

1) If you do not act like an ordinarily prudent person, then you are negligent. But we don’t care about regular negligence in the BJR.
2) Gross negligence will trigger liability under the BJR unless there is a liability waiver.
3) Waste “tends to show” that there was bad faith. However, not necessarily. If there was bad faith, then liability waiver will not save you from liability.
4) Bad faith will trigger liability under the BJR and there can be no liability waiver.

Question 28

What is a liability waiver?

Answer 28

A charter can include a liability waiver (and it must include it if you want to use it) that eliminates the personal liability of a director to the corporation or its stock holders for monetary damages for breach of a fiduciary duty in a business decision.

Question 29

When is a liability waiver not applicable (3)

Answer 29

1) For any breach of the duty of loyalty.
2) For any act of omission that is in bad faith (not good faith)
3) For any transaction from which the director received an improper personal benefit.

Question 30

DGCL 145(a) allows a corporation to indemnify directors and officers for liability unless….(2)

Answer 30

1) The person did not act in good faith.

2) The director is convicted in a criminal proceeding.

Question 31

Is indemnification under 145(a) the exclusive right of those seeking indemnification?

Answer 31

No. There is always liability insurance (D&O insurance)

Question 32

Could a charter or bylaw include indemnification for actions done in bad faith?

Answer 32

Nope. (See Waltuch)

Question 33

What is D&O liability insurance

Answer 33

It is directors and officer liability insurance. Essentially, it is insurance that a company can purchase to protect fiduciaries from personal liability.

D&O insurance is the last line of defense if a director acts in bad faith, as it is another right of those that are seeking indemnification.

Question 34

What is the mandatory reimbursement of legal expenses for directors all about?

Answer 34

Under DGCL 145(c) a corporation must reimburse a director for legal expenses incurred in a successful defense of claims against officers and directors. (It must do this even if it doesn’t have insurance or choose to indemnify them.)

Question 35

What duty can cause a director to be liable for omissions? (doing nothing when you should have)

Answer 35

The duty to monitor.

Question 36

What is the “BJR-style” rule in the case of director omissions in violation of the duty to monitor?

Answer 36

The red Flag rule

Question 37

What is the red flag rule?

Answer 37

While there is no BJR in cases of director omissions, directors do not have an affirmative duty to monitor for violations (per se, but see below) of the law unless there is a RED FLAG. But, they must monitor after some clear-cut warning, some obvious read flag. (Allis Chalmers). Additionally, not having a monitoring system that monitors for criminal or fraudulent activity activity is enough for liability. There is no liability for failing to monitor for business risk (Citibank relying on Stone which relied on Caremark)

Question 38

What is an example of a red flag?

Answer 38

Failing to read financial statements when a director starts co-mingling funds and making a shareholder loan account and take reasonable steps to monitor for fraud.

Question 39

Is resigning enough to prevent liability when you see a red flag?

Answer 39

Sometimes, but other courts have held that this would be okay. In Francis, the court held that she needed to hire an attorney to stop the conversion. This shows that courts do not give as much difference for omissions.

Question 40

Do directors have an affirmative duty to monitor for violations of the law if there are no red flags?

Answer 40

Currently, yes. Directors must require that there be monitoring systems in place for criminal or fraudulent conduct, but not with respect to conduct that gives rise to business risk. (Citibank, relying on Stone, which relies on Caremark lol).

Question 41

Does a corporations large size give legitimacy to the red flag rule?

Answer 41

Yes, it is harder to monitor a large company in an efficient way.

Question 42

Does Federal Law gives incentives for a director to monitor for law breaking even though there are no red flags?

Answer 42

Yes! There are various provisions. Some include high fines for corporate defendants, a downward adjustment in punishment if there is compliance with ethics programs, prosecutors will look at depth of compliance programs when charging, CEO must identify material weakness to outside auditors of their controls.

Question 43

Do the federal incentive to monitor for law breaking make implementing a compliance program part of a director’s duty of care?

Answer 43

Yes! Even though they do not have to under state law. Because these incentives exist, a director likely violates his duty of care by not implementing these programs.

Question 44

Can generalized market trends serve as red flags that misconduct is occurring in a company?

Answer 44

No (Citibank)

Question 45

If a business decision is also a violation of the law, will the BJR protect it?

Answer 45

No! A knowing violation of the law will not protect a director. Shareholders are entitled to recover when directors cause waste with unlawful acts. (Miller v. At&T)

Question 46

Under 102(b)(7) are there protections for violations of the duty of care if there was an act or omission that involved intentional misconduct or a knowing violation of the law?

Answer 46

No

Question 47

Can corporations indemnify if the directors of officers break the law?

Answer 47

No. According to 145(a) a defendant must have no reasonable cause to think their actions were illegal.

Question 48

What happens if a board’s decision violates the company;s fundamental documents?

Answer 48

The Chancery Court in Delaware has held that the BJR does not protect the directions in this case.

Question 49

1. Directors of corporations are subject to the duty of care, which basically requires that directors perform their functions in the good faith belief that their actions are in the best interest of the corporation and with the care of an ordinarily prudent person in similar circumstances (e.g., ALI § 4.01(a)). This duty implies that if a court finds that a director implemented a business decision that caused financial damages to the corporation, and that an average director would not have implemented such a decision, the director will be liable for breach of the duty of care.

A. True
B. False

Answer 49

B. False. A director can be shielded in a variety of ways.

With regard to the BJR, it imposes a higher threshold (at least gross negligence or bad faith.)

Question 50

Suppose that the directors of a small local bank (“Local Bancorp”), the only bank in this community, decide to significantly raise the interest rate that the bank charges for commercial loans. The maximum interest rate is 25% and they will now charge borrowers a 24.9% rate. They want to implement this change because they want to reduce the funds they use to study so many loan applications, and they expect that the higher interest rate will exceed any loss of customers. Moreover, the directors want to implement this change even though they know many borrowers in this community (e.g., small businesses) will no longer be able to rely on formal banking loans, which will cause many negative effects. For example, many businesses will need to close, and others will need to turn to alternative sources of financing, including “payday loans” made by clandestine lenders – which are illegal in this state. A couple of years after Local Bancorp’s increase in interest rates, more borrowers than expected migrated to payday loans, and this migration was not compensated by higher income from the higher interest rates, which resulted in significant losses for Local Bancorp.

Some shareholders sued the directors for breach of the duty of care, arguing that because the increase in interest rates forced many borrowers to resort to payday loans, which in turn caused significant losses for the bank, the decision is not protected by the business judgment rule. This is a “knowing violation of the law,” which, like in Miller v. AT&T (1974), should result in liability. Are the directors liable?
A. Yes
B. No

Answer 50

No. The directors did not violate the law.

Question 51

Suppose that the directors of a small local bank (“Local Bancorp”), the only bank in this community, decide to significantly raise the interest rate that the bank charges for commercial loans. The maximum interest rate is 25% and they will now charge borrowers a 24.9% rate. They want to implement this change because they want to reduce the funds they use to study so many loan applications, and they expect that the higher interest rate will exceed any loss of customers. Moreover, the directors want to implement this change even though they know many borrowers in this community (e.g., small businesses) will no longer be able to rely on formal banking loans, which will cause many negative effects. For example, many businesses will need to close, and others will need to turn to alternative sources of financing, including “payday loans” made by clandestine lenders – which are illegal in this state. A couple of years after Local Bancorp’s increase in interest rates, more borrowers than expected migrated to payday loans, and this migration was not compensated by higher income from the higher interest rates, which resulted in significant losses for Local Bancorp.

Related question about today’s materials: In the same scenario described above, suppose that Local Bancorp is incorporated in Delaware and that many small entrepreneurs in fact closed their businesses because they did not have access to financing after the increase in interest rates. In light of this, another group of shareholders in Local Bancorp sued the directors, arguing that the directors owe fiduciary duties not only to the shareholders, but also to their local communities; therefore, they should be liable for the systematic bankruptcies they caused. Are the directors liable on this basis?
A. Yes
B. No

Answer 51

No. In Delaware the directors only owe fiduciary duties to the corporation and shareholders.

Question 52

3. In Delaware law, directors of corporations are liable for breach of their duty to monitor for corporate wrongdoing only if there are clear red flags of misbehavior.
   A. True
   B. False

Answer 52

False. According to Citibank they must at least monitor for fraudulent or criminal misconduct.

Question 53

Which of the following is incorrect with regard to corporations?

A. Under Allis-Chalmers, large or highly decentralized companies continuously trigger the directors’ duty to monitor, which implies that the directors will be liable for administrative sanctions caused by antitrust violations and other forms of corporate wrongdoing.

B. Courts differentiate a board’s duty to monitor for fraud and the duty to monitor for business risk. Directors may be liable only for failing to monitor for fraud.

C. Residential Mortgage Backed Securities, such as those in Citigroup, are considered beneficial because they reduce the risk premium—but, on the downside, reduce the incentives for monitoring.

D. Although the Delaware Supreme Court endorsed Caremark in Stone, the opinion considerably attenuated Caremark’s holding.

Answer 53

A. Even under Allis-Chalmers, these aspects do not trigger liability per se.

Question 54

What is Caremark’s holding regarding the duty to monitor?

Answer 54

A poor monitoring system by itself can be enough to trigger liability, even absent red flags.

Directors have an affirmative duty to seek out red flags by staying informed.

Citibank now controls.

Question 55

What is the Stone holding regarding the duty to monitor?

Answer 55

In order to be liable for failure to monitor, even absent red flags, a director must:

1) Utterly fail to implement any reporting information systems or controls; or
2) Having implemented such controls, consciously fail to monitor or oversee its operations.