The Law Office of J.R. Smith presents the January 2024 topic series, “Fiduciary Duties.”
Each week the firm will explore the duties imposed upon various leadership roles in various business entities.[1]
Fiduciary Duties of the Board of Directors
Corporations formed in Delaware but operating in Texas evidenced unprecedented corporate migration between 2020-2023. This topic focuses on the fiduciary duties of the Board of Directors for Delaware formed corporations who are operating in the state of Texas. This article is a high-level overview and only scratches the surface of a very complex topic.
Directors of a corporation are tasked with protecting the interests of the corporation and to act in the best interests of its stockholders. The business and its affairs are managed by the directors who are guided by their fiduciary duties in this capacity.
Duties owed to whom?
Common Stockholders: Directors owe fiduciary duties to the corporation and its stockholders. Generally speaking, the term “stockholders” means the common and preferred stockholders equally unless there is a divergent interest of the classes. In the event that preferred stockholders contractually rely on the terms and conditions subject to the certificate of designation, the duties of the directors’ stem only to the common shareholders.
Creditors: Directors of an insolvent corporation maintain their fiduciary duties to the corporation, but in place of the stockholders, the creditors take their place as the primary beneficiaries of those duties.
Controlling stockholder: This person or entity owes fiduciary duties to the corporation and minority stockholders if it owns 50% or more of the voting power or otherwise exercises control over the affairs of the corporation.
Officers: Like directors, officers of a corporation share the duties of care and loyalty to the corporation.
Corporation: The corporation itself does not owe the shareholders any fiduciary duties and cannot aid or abet any of the directors in their breach of duties.
Common Law Duties of Directors
Directors owe two primary duties in their role: a duty of care and a duty of loyalty. Under Delaware law, the subsidiary duties that stem from these primary duties are duties of good faith, disclosure, and oversight.
Duty of Care
Delaware courts have described this duty to mean that the director must act and use the amount of care in which an ordinarily careful and prudent person would use in similar circumstances. Breach of that duty can occur when the director(s) fails to act in a situation where a careful person would have taken action. That being said, the business judgement rule governs the analysis of the business decisions and courts are reluctant to armchair quarterback the directors’ decisions as a form of hindsight analysis.
Often misunderstood is that the duty of care does not mean the director is required to maximize profits or is responsible for minimizing taxes of a corporation, as long as there is a rational business purpose. Often shareholders seek a derivative suit on this basis, which fails on its face unless there is stark evidence that the directors failed to act carefully or prudently.
Duty of Loyalty
This duty requires the directors to act in good faith for the benefit of the corporation and its stockholders, not for their own benefit or personal interests. Just as important as what this duty imposes, it conversely prohibits conduct that would harm the corporation and shareholders. Breaches of this duty cannot be overcome by the business judgment rule or statutory limitations. It is one of the few duties in which a director cannot escape liability for acts of bad faith and self-dealing.
Examples of breach of loyalty and analysis used by the courts:
Corporate Opportunity Doctrine: This breach occurs when the director usurps a corporate opportunity. Courts look at the following factors in analyzing whether breach has occurred:
o Is the opportunity in the same line of business as the corporation?
o Does the corporation have an interest in or expanding upon this opportunity?
o If so, would the corporation even be able to do so financially?
o Does this opportunity create a conflict of interest?
Insider Trading: Directors can breach their duty of loyalty with insider trading. The director is found to be in breach if the corporation can show the director:
o Possessed material nonpublic information about the company AND
o Used this information to make trades because he/she/it was motivated by this information, whether in whole or in part.
Director Protections
The threat of liability naturally comes with director positions. However, to keep qualified and intelligent personnel making sound decisions, Delaware law has adopted protection measures for directors such as:
· Business Judgement Rule,
· Limited liability for breaches of duty of care,
· Indemnification and expenses advancement, and/or
· Insurance (D&O).
Other Examples of Breach: Acting in Bad Faith
The duty of good faith is analogous to the duty of loyalty and is not a standalone duty. When acting in bad faith, a director can no longer rely on any exculpation or the business judgment rule for protection. Gross negligence is a common denominator in most cases. Some examples of bad faith are:
Conduct motivated by an actual intent to do harm,
Flagrant disregard for acting when one must do so to protect the corporation,
Committing a knowing violation of law, the company charter, or failure to prohibit others from doing so,
Acting for any other purpose other than advancing the corporation or stockholders best interests,
Intentionally violating the equity plan, and/or,
Completely abdicating its directorial duties to a person or entity with a known conflict of interest.
Caremark Claims
Caremark claims usually stem from accusations that the board did not oversee the corporation’s operations to the extent that results in a conscious disregard of its duty. The board must make good faith efforts to create AND implement an information reporting system in order to effectuate its oversight of corporate operations and risk assessment. These information systems must be put in place in order to timely and accurately inform the board of operations AND address compliance risks, especially mission critical compliance risks. Establishing a Caremark Claim is arguably one of the most difficult legal claims to make, therefore, the information posted below is just a generalize summary for the purposes of liability discussions.
After implementation of the information system/controls, the directors must continuously monitor and oversee operations to avoid oversight liability. Some examples of oversight liability have stemmed from:
Evidence of corporate misconduct that put directors on notice of misconduct, but were consciously disregarded by the directors,
Red flags sufficiently connected to corporate trauma that would put a reasonable observer on notice,
Intent by the directors to disregard, act slowly, or not act at all, once on notice of corporate misconduct.
Avoiding a Caremark Claim
To avoid oversight liabilities, the board of directors must take proactive action and record those efforts as well. As a shortlist, directors should:
1. Establish a board level oversight system that does not rely on just management or outside regulation for oversight of corporate activities.
2. Ensure the oversight system focuses on central compliance risks, legal exposures, and mission critical risks.
3. Actively use and monitor the oversight system for red flags and non-compliance.
a. If red flags are found or suspected, act immediately and follow up consistently until the threat is terminated.
4. Maintain a record by the board of directors to show use of the oversight information system and response actions. These records will evidence directors acting in good faith if they contain, at a minimum, the following:
a. Oversight System: Establishment and Protocols and the implementation date (as needed);
b. Compliance issues identified, reviewed, and discussed;
c. Acts evidencing “follow ups” on red flags, potential compliance issues, or other threats; and
d. Implementation and monitoring of remedial measures taken to abate the compliance issues.
New Areas of Risk related to Oversight Claims
The constant evolution of business creates ways for directors to face oversight challenges related to Environmental, Social, Governance (ESG) compliance, Cybersecurity Risks, and Artificial Intelligence. These areas are ripe for litigation due to new regulations encompassing corporate duties and compliance.
Seeking Legal Assistance
The board of directors, in an effort to ensure that their duties are being met, that their oversight program is sufficient, or for any other purpose that would be in the best interest of the corporation and its shareholders, can and should seek outside legal counsel for analysis and feedback. The Law Office of J.R. Smith offers legal services to help the board and/or the corporation ensure that it’s taking the necessary steps to meet its obligations. Call 682-900-1799 or email info@lojrs.com to schedule a free consultation today.
[1] These articles are meant to be educational in nature and are not to be considered legal advice.
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