What Duties Do Corporate Decision Makers Owe to the Corporation? - June 14 + June 21 Flashcards
What is a fiduciary? (Epstein)
A fiduciary is someone who acts in the interest of someone else. (227)
What duties do managers owe to the businesses they manage? (Epstein)
Managers owe a duty of care, a duty of loyalty, and a duty of good faith. (227)
What is the business-judgement rule? (Q)
Doctrine that protects corporate officers and directors from the imposition of liability for bad business decisions.
Are corporate directors fiduciaries? (Q)
Yes. Every member of the board of directors is a fiduciary who may be held liable to the corporation, shareholders, and third parties for violating certain duties. If held liable, a director may seek indemnification by the corporation in some situations.
What does the duty of care require of directors and key officers of a corporation? (Q)
The duty of care requires a director or key officer of a corporation to act as a reasonably prudent person in the same position or similar circumstances would act when making decisions for the corporation. A reasonably prudent person typically exercises due care and avoids unnecessary risks of harm.
When making decisions or conducting oversight, a director must exercise the care that a person in a like position would reasonably believe to be appropriate under similar circumstances. In particular, a director must devote timely attention to the ongoing oversight of the business and affairs of the corporation. A director with special knowledge or skill is obligated to use such knowledge or skill when acting on behalf of the corporation.
A woman worked for a corporation and supervised an employee with repeated performance issues. The woman filed extremely critical year-end reviews of the employee for three years in a row. The woman then became a member of the corporation’s board of directors. The corporation was considering buying a facility. The woman learned that the bad employee was providing key valuation insight for the purchase. Based on the employee’s reports, the board of directors determined that the facility was worth $100,000, and the corporation bought the facility for that price. The corporation later discovered that the employee had made serious errors, and the facility was worth only $50,000. Several shareholders threatened to sue for the bad investment.
In her role as a director, can the woman insulate herself from personal liability by claiming that she relied in good faith on the employee’s reports? (Q)
No. The woman cannot avoid personal liability by claiming that she relied in good faith on the employee’s reports. A director must exercise the care that a person in a like position would reasonably believe to be appropriate under similar circumstances. Directors are entitled to rely on employees’ reports and are insulated from personal liability for claims that can be traced directly to errors in that work—but only if the director reasonably believes the employee is reliable and competent.
Here, as a director, the woman owed a duty of care to be fully informed before acting for the corporation. The woman had supervised the employee and knew that he was not reliable or competent. A reasonable person in the same position would know not to rely on that employee’s work. Thus, the woman cannot avoid personal liability for a claim that she breached of her duty of care.
A corporation was contemplating the purchase of a parcel of land. The land was listed for sale at $100,000. For the transaction, the board of directors had retained a real estate attorney who had been an appraiser for 20 years before going to law school. The directors also asked the real estate attorney to value the property. The attorney responded that $100,000 represented the parcel’s fair market value. The corporation agreed to buy the parcel for $100,000. The following month, a comparable property sold for $45,000. Shareholders were furious after learning that the directors’ appraisal assessment was based on an attorney’s opinion.
Did the directors breach their duty of care by relying on the attorney’s appraisal opinion? (Q)
No. The directors did not breach their duty of care by relying on the attorney’s appraisal. A director must exercise the care that a person in a like position would reasonably believe to be appropriate under similar circumstances. Directors are entitled to rely on the work of professionals and are insulated from personal liability for claims that can be traced directly to errors in the professional’s work—as long as the work is on matters that are within the particular person’s competence.
Here, the directors relied on an attorney’s appraisal. Generally, attorneys are not trained appraisers. However, a reasonable person in the same position would conclude that this particular attorney merited confidence as to valuation matters because she had worked as an appraiser for 20 years. Thus, the directors were entitled to rely on the attorney’s appraisal and did not breach their duty of care.
What is the business judgment rule? (Q)
The business judgment rule is a defense to a claim for breach of the duty of care that protects corporate officers and directors from the imposition of liability for bad business decisions.
Generally, officers and directors are not held liable for informed decisions that were not intended to harm the corporation or shareholders. The business judgment rule recognizes that shareholders voluntarily undertake the risk of bad business judgment and that corporate profitability may require that directors not be overly cautious and act with speed despite risk.
What are the elements of a defense based on the business judgment rule defense? (Q)
The elements of a defense based on the business judgment rule are that a director or officer of a corporation made an honest business decision:
in good faith,
in the corporation’s best interests,
after a reasonable investigation, and
without a personal interest in the subject.
The rule protects both decisions to act and decisions not to act. A court will generally defer to directors’ business judgments by declining to make a hindsight evaluation of the reasonableness of their business decisions or to substitute its judgment for that of the board absent evidence of misconduct.
A corporation was considering investing part of its cash reserves in mortgage-backed securities. The board of directors undertook a thorough evaluation of the investment options and determined that the corporation would likely realize significant profits from the investment. None of the directors had an interest in any of the investment options, and all were acting in good faith in what they believed were the best interests of the corporation. Unfortunately, the investment was a disaster, and the shareholders were furious. The shareholders claimed that the directors violated the duty of care by not acting as reasonably prudent persons in their positions would.
Can the directors successfully use the business judgment rule as a defense to the shareholders’ claim? (Q)
Yes. The directors can use the business judgment rule as a defense to the claimed breach of the duty of care. The business judgment rule protects directors who make informed decisions that were not intended to harm the corporation or its shareholders. Under the business judgment rule, a director is not liable for a breach of the duty of care for an honest business decision made:
in good faith,
in the corporation’s best interests,
after a reasonable investigation, and
without a personal interest in the subject.
Here, the claim is for a breach of the duty of care. This means the business judgment rule may apply. The directors acted in good faith, in the corporation’s best interests, after a thorough investigation, and had no personal interests in the investment. Thus, the directors meet all the criteria and can use the business judgment rule as a complete defense to the shareholders’ claim.
A corporation learned of a potential contamination issue involving some of the dietary supplements it manufactured. The board met to discuss the issue. The board heard numerous presentations from employees and scientists. The board believed that the risk of harm to its clients was miniscule, but the cost of a proper recall would plunge the company into bankruptcy. The board voted to take no action. None of the directors had a personal interest in the matter, and all voted in good faith. Unfortunately, a few of the corporation’s celebrity clients become ill after taking the supplements, and posted messages on social media disparaging the products. The corporation’s sales plummeted, and shareholders claimed that the directors breached the duty of care by not issuing a recall.
May the directors rely on the business judgment rule to defend against this claim? (Q)
Yes. The directors may rely on the business judgment rule as a defense to the shareholders’ claim that the directors breached the duty of care. Under the business judgment rule, a director is not liable for a claimed breach of the duty of care for an honest business decision made:
in good faith,
in the corporation’s best interests,
after a reasonable investigation, and
without a personal interest in the subject.
Here, the directors are facing a claimed breach of the duty of care, making the business judgment rule a potential valid defense. The board’s conduct meets all the criteria to rely on the rule: an unconflicted board conducted a reasonable investigation in good faith and made a decision that it believed was in the corporation’s best interests. Even though the board’s decision was to take no action at all, the business judgment rule still protects this informed failure to act.
What is the entire-fairness defense? (Q)
The entire-fairness defense is a defense under which a director facing a claim for breach of the duty of care may be insulated from liability if she can establish that the transaction in question produced a fair price after a fair negotiation process. The price should approximate fair market value and there should be no evidence of self-dealing or manipulation by the director.
This defense is available to a director who has made a business decision without conducting a reasonable investigation and therefore cannot invoke the business judgment rule.
If a director made a business decision without conducting a reasonable investigation, what defense or defenses may the director use to avoid liability for the decision? (Q)
If a director made a business decision without conducting a reasonable investigation, the director may use the entire-fairness defense to avoid liability for the decision.
The business judgment rule is not available as a defense in this case because that rule requires the director to have conducted a reasonable investigation and made an informed decision based on that investigation.
A corporation was considering selling its fleet of corporate vans. The directors received only one bid, for $1 million. The bid was good for 24 hours. The directors considered appointing a subcommittee to determine the fair market value of the vans but realized that they did not have time to do that within the 24-hour window. Ultimately, the directors voted to accept the bid without any substantive review. Shortly after the sale, the directors learned that the aggregate value of the vans was only $650,000. A few shareholders learned about the hasty process involved in selling the vans and alleged that the directors had breached their duty of care.
What defense can the directors invoke to try to avoid liability for the shareholders’ claim that the directors breached their duty of care? (Q)
The directors can invoke the entire-fairness defense as a defense to the shareholders’ claim. Under the entire-fairness defense, a director facing a claim for breach of the duty of care may be insulated from liability if she can establish that the transaction in question produced a fair price after a fair negotiation process. This defense is available to a director who has made a business decision without conducting a reasonable investigation and therefore cannot invoke the business judgment rule.
Here, the directors may not invoke the business judgment rule because they did not undertake a reasonable investigation before selling the vans. However, the corporation received a more than fair price for the vans. Thus, the directors may invoke the entire-fairness defense to try to avoid liability for the claimed breach of the duty of care.
If a director breaches a fiduciary duty, may her actions subsequently be approved by the board of directors? (Q)
Yes. If a director breaches a fiduciary duty, her actions may be approved by the board of directors. This is known as ratifying the director’s action.
Typically, the board of directors may adopt a resolution ratifying the action and obtain shareholder approval for the ratification. If an action is successfully ratified, the breaching director will not be held liable for a breach of duty.
