Avoid Shareholder Lawsuits by Understanding Director Fiduciary Duties

I had a professor in law school who could spend days discussing all the nuances of fiduciary duties for directors in privately held corporations. We literally spent 8 weeks of a 10-week quarter primarily talking about all the ins and outs of this dry (yet important) subject. As fond as I was of that professor, and that course, I’ll spare you the 8-week discussion and instead give you a very high-level primer of the basics of director fiduciary duties for privately held Delaware and Washington corporations.

The Two Duties – Loyalty and Care

At the highest level, director fiduciary duties can be summarized as two primary duties: the duty of loyalty; and the duty of care.

Duty of Loyalty

The duty of loyalty means that the director puts the interests of the corporation and its shareholders before the director’s own personal interests when making decisions for the corporation. The duty of loyalty also encompasses the “corporate opportunity doctrine,” which essentially means that directors of the corporation will not improperly divert business opportunities of the corporation for their own personal benefit. For example, a violation of the corporate opportunity doctrine could occur if a director of a retail company that is looking to expand into a new geographic market hears about a property owner that is trying to sell a retail building for cheap, and the director uses that knowledge to purchase the building, and then leases the building back to the corporation at a market rate. In this case, the director learned of a business opportunity that would benefit the corporation (the ability to acquire a desirable building in a desirable new market at a below-market price), but the director used that knowledge not for the corporation’s benefit, but for his own personal benefit. A proper course of action for the director would be to disclose to the corporation his knowledge of the opportunity to acquire a desirable retail space at a discount to the market price. If the corporation passed on this opportunity after giving it proper consideration, then it would be appropriate for the director to purchase the building.

Duty of Care

The duty of care requires that the directors perform their duties in good faith and with the care an ordinarily prudent person in a like position would exercise under similar circumstances. It is important to note that “care” does not mean “skill,” as technical competence is not considered a prerequisite for service as a director. The duty of care can best be described as proceeding with a critical eye in assessing information; performing actions carefully, thoroughly, and thoughtfully and in an informed manner; and seeking all relevant material information before making decisions on behalf of the corporation.

The Business Judgment Rule

In Washington and Delaware, the courts have no interest in playing “Monday morning quarterback” and second-guessing the quality of decisions made by boards of directors with the benefit of hindsight. The courts understand that sometimes all of the facts aren’t available before making a decision; that boards of directors may rely on advice of experts, legal counsel, and other advisors for matters outside the board’s expertise (some of which may be based on faulty logic or assumptions); and that extended periods of deliberation are not always available in the corporate world.

Keeping these things in mind, if the directors of a Washington or Delaware corporation fulfill their fiduciary duties of loyalty and care, the courts will typically defer to the business judgment of the board of directors when reviewing their decisions and presume that they were made in good faith, on an informed basis, and with the honest belief that they were made in the best interests of the company and its shareholders. The presumption of the business judgment rule can be rebutted by showing that the directors did not properly exercise their fiduciary duties – but where the business judgment rule applies, directors are given wide latitude with respect to decisions they made at the time of the transaction.

Best Practices to Fulfill Fiduciary Duties

You can take a number of steps to help ensure that you adequately fulfill your fiduciary duties as a member of a board of directors:

Due Diligence

One of the primary tenants of the duty of care is that a director take the time to investigate and evaluate the merits of a transaction. This involves taking a step back to review relevant documents and disclosures; weighing the costs, benefits, and risks associated with such transaction; and making a thoughtful and informed decision.

Engage Experts

Hand-in-hand with the general duty of performing due diligence is engaging experts in areas outside the board’s expertise. This includes legal counsel, financial advisors, and other trusted advisors who the board can rely upon for counsel and advice. Under the business judgment rule, the courts will generally respect decisions that directors made in reliance upon advice of experts – so long as the board didn’t have reason to believe at the time that such advice was flawed.

Follow Process

Following a thoughtful decision-making process will help ensure that thoughtful decisions are being made.  Lively discussion of issues and thought-sharing should be encouraged when the board of directors is evaluating a transaction or course of action.

Hold Regular Meetings

It is generally a good idea to hold board meetings at least quarterly. This is especially true if you have outside directors who are not members of the management team – and therefore are not as close to the day-to-day operations of the company. Along with regular meetings, special meetings should be held as needed to approve time-sensitive transactions.

Maintain Good Records

Every time a corporation has a board meeting, it should have clear, well-drafted meeting minutes prepared shortly thereafter. Additionally, any time the board takes action by unanimous written consent in lieu of a meeting, the consent action should be written very clearly and contain all material facts upon which the consent is based. Board meeting records (along with exhibits) should be maintained in the corporation’s minute book. If a decision is ever challenged by a shareholder, keeping clear and thorough records will help exhibit that the board has done its diligence and followed the necessary corporate process. Furthermore, keeping a well-maintained minute book will prevent you from spending significant time piecing things together after the fact.