What They Do in Delaware

The fundamental responsibility of the board of directors of a corporation is to oversee and supervise the management of the corporation's business. All directors of a corporation, whether or not “independent,” owe fiduciary obligations to the company and its stockholders. These fiduciary obligations include the duty of care and the duty of loyalty, and, within these duties, a duty of disclosure. The precise enunciation of these fiduciary obligations varies among states. The following discussion is based on the law of Delaware, in which a large proportion of public companies are incorporated.

Fiduciary Obligations

Duty of Care

In general, the duty of care requires directors to:

• discharge their duties in good faith;
• exercise the care that a prudent person in a like position would exercise under similar circumstances; and
• act in a manner reasonably believed to be in the best interests of the corporation.

A director must comply with the duty of care whether making a specific business or overseeing the corporation's business and affairs generally.

Oversight Function

In overseeing a corporation's business and affairs, directors must exercise reasonable care to ensure that the corporation's executives are meeting their managerial responsibilities. To carry out their oversight function, directors must receive adequate information from management about the corporation's business on a timely basis. The duty of care requires the director to review such information and make further inquiries with management regarding the information when necessary. If a director does not receive information about the corporation's business operations from management on a timely basis, or the information provided is inadequate for the director to properly carry out the oversight function, the director is responsible for pursuing these matters with management.

Making Informed Business Decisions

The duty of care requires directors to make reasonable efforts to reach informed business decisions. The determination whether directors have made an informed business decision is based upon:

• whether prior to making a decision the directors have received all material information in time to evaluate it; and
• whether the directors have reasonably informed themselves regarding alternatives before reaching a decision.

Duty of Loyalty

The duty of loyalty is the director's affirmative obligation to protect the interests of the corporation and to refrain from conduct that would injure the corporation or deprive it of profit or advantage. Cases involving breach of the duty of loyalty frequently involve conflicts of interest between directors or management, on the one hand, and with the corporation and its stockholders, on the other, for example, director self-interested transactions or usurpation of corporate opportunities.

Although state corporation laws generally do not prohibit transactions between a corporation and its directors, in such transactions, directors must avoid breaching their duty of loyalty. Accordingly, a director who intends to enter a transaction with a corporation should disclose all material information regarding the transaction and obtain the approval of a majority of disinterested directors and, if necessary, the stockholders,.

Delaware courts have recently broadened their view of what might constitute a conflict of interest, holding that two directors who were professors of a university could not impartially decide whether litigation should be brought against other directors with close connections to the university or a director who was planning to make a large donation to the school.

Duty of Disclosure

The duty of disclosure requires directors to fully and fairly disclose all material information within the board's control when the directors seek stockholder action and requires directors to know that the information disclosed to stockholders is true.

Special Fiduciary Obligations in Insolvent Companies

The directors' fiduciary obligations do not differ when the corporation is insolvent, but the persons to whom the fiduciary obligations are owed may change. Directors of a solvent corporation generally do not have fiduciary obligations to creditors. When a corporation becomes insolvent, however, the directors stand as trustees of the corporate properties for the benefit of creditors first and stockholders second, and their primary fiduciary obligations accordingly shift from stockholders to creditors.

Special Fiduciary Obligations in Companies 'In Play'

When the sale of “break-up” of a company becomes inevitable, the board has an additional fiduciary obligation to maximize the corporation's value for the stockholders' benefit. The so-called “Revlon duties” charge directors with the duty of selling the corporation at the highest price reasonably attainable.

Liability in Relation to Fiduciary Obligations

The Business Judgment Rule

The business judgment rule is a presumption by the courts that business decisions are made by disinterested directors, on an informed basis and with good-faith belief that the business decision will serve the best interests of the corporation. The practical effect of applying the business judgment rule in a breach of duty case is that the court, without making any inquiry, will assume that a director has complied with his or her fiduciary duties and therefore is not liable. The business judgment rule presumes that directors in making a business decision have met the five elements of the rule. They are as follows:

• The subject of the decision was about business matters of the corporation;
• The director was disinterested, meaning that the director did not have a personal stake in the outcome of the decision and was not subject to influences other than the corporate merit of the subject matter of the decision;
• The director exercised due care by making the decision on an informed basis;
• The director acted in good faith, meaning the director did not make the decision for some purpose other than a genuine attempt to advance corporate welfare; and
• The director did not abuse his or her discretion by making a decision that is not attributable to any rational business purpose.

Unless it is shown that one of these elements was lacking in the decision-making, the court will not substitute its judgment for that of the board of directors. Accordingly, if directors have complied with their fiduciary obligations, they generally will not face liability for business decisions alleged to have injured the corporation or its stockholders.

Independent Review of Directors' Decisions

If criteria for invoking the business judgment rule are not satisfied, the court will independently review the board's decision and determine any liability of the directors for any harm resulting from it. Personal liability for breach of duty of care requires gross negligence, not merely negligent conduct, by directors. In this context, gross negligence means the directors acted with reckless indifference to or in deliberate disregard of the interests of the corporation or its stockholders, or took actions that are outside the bounds of reason.

If a court determines that a director breached his or her duty of loyalty by entering a transaction with the corporation, the director will be liable to the extent the transaction was not fair to the corporation. Fairness in this context means that there was fair dealing in effecting the transaction and that the price of the transaction was fair.

Charter Exculpation

Delaware law authorizes a corporation's certificate of incorporation to contain a provision “eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages” for breach of the fiduciary duty of care. In some states, broader exculpation, including for breach of the duty of loyalty, is permitted.

In Delaware, the scope of exculpation has narrowed, as duty of care claims are sometimes recharacterized as duty of loyalty cases. The courts recently have focused on the duty of good faith, in one case holding that a board could not avail itself of the business judgment rule, because it failed to exercise any business judgment at all respecting negotiation of an executive officer's employment contract and termination.

Liability in Connection with Federal Securities Laws

Applicable Provisions

Subject to a due diligence defense, the Securities Act of 1933 imposes liability on any director of a corporation filing a registration statement making material misstatements or omissions. The Securities Exchange Act of 1934 sets forth, with respect to plaintiff class actions, the criteria for determining the proportionate liability of so-called “covered persons,” including outside directors, and the rights of contribution, if any, of the covered persons. In general, these factors include whether any violation of securities law was knowing; the egregiousness of the person's conduct; and the extent to which it contributed to the plaintiffs' losses.

SEC Enforcement

Recent enforcement actions by the SEC have focused increasingly on the involvement of directors in the preparation of periodic reports containing materially misleading statements or omissions. The SEC has generally targeted inside directors in such cases. However, the expanded responsibilities imposed on outside directors by the Sarbanes-Oxley Act could lead to an increased focus on outside directors in connection with these types of investigations. In the event of an investigation, the SEC may make public a report of the investigation and, if warranted, the SEC can issue cease-and-desist orders or assess civil or criminal penalties against the corporation and the culpable directors and officers. The extent to which a person cooperates with or attempts to hinder an SEC investigation can significantly affect the severity of any penalty.

The fundamental responsibility of the board of directors of a corporation is to oversee and supervise the management of the corporation's business. All directors of a corporation, whether or not “independent,” owe fiduciary obligations to the company and its stockholders. These fiduciary obligations include the duty of care and the duty of loyalty, and, within these duties, a duty of disclosure. The precise enunciation of these fiduciary obligations varies among states. The following discussion is based on the law of Delaware, in which a large proportion of public companies are incorporated.

Fiduciary Obligations

Duty of Care

In general, the duty of care requires directors to:

• discharge their duties in good faith;
• exercise the care that a prudent person in a like position would exercise under similar circumstances; and
• act in a manner reasonably believed to be in the best interests of the corporation.

A director must comply with the duty of care whether making a specific business or overseeing the corporation's business and affairs generally.

Oversight Function

In overseeing a corporation's business and affairs, directors must exercise reasonable care to ensure that the corporation's executives are meeting their managerial responsibilities. To carry out their oversight function, directors must receive adequate information from management about the corporation's business on a timely basis. The duty of care requires the director to review such information and make further inquiries with management regarding the information when necessary. If a director does not receive information about the corporation's business operations from management on a timely basis, or the information provided is inadequate for the director to properly carry out the oversight function, the director is responsible for pursuing these matters with management.

Making Informed Business Decisions

The duty of care requires directors to make reasonable efforts to reach informed business decisions. The determination whether directors have made an informed business decision is based upon:

• whether prior to making a decision the directors have received all material information in time to evaluate it; and
• whether the directors have reasonably informed themselves regarding alternatives before reaching a decision.

Duty of Loyalty

The duty of loyalty is the director's affirmative obligation to protect the interests of the corporation and to refrain from conduct that would injure the corporation or deprive it of profit or advantage. Cases involving breach of the duty of loyalty frequently involve conflicts of interest between directors or management, on the one hand, and with the corporation and its stockholders, on the other, for example, director self-interested transactions or usurpation of corporate opportunities.

Although state corporation laws generally do not prohibit transactions between a corporation and its directors, in such transactions, directors must avoid breaching their duty of loyalty. Accordingly, a director who intends to enter a transaction with a corporation should disclose all material information regarding the transaction and obtain the approval of a majority of disinterested directors and, if necessary, the stockholders,.

Delaware courts have recently broadened their view of what might constitute a conflict of interest, holding that two directors who were professors of a university could not impartially decide whether litigation should be brought against other directors with close connections to the university or a director who was planning to make a large donation to the school.

Duty of Disclosure

The duty of disclosure requires directors to fully and fairly disclose all material information within the board's control when the directors seek stockholder action and requires directors to know that the information disclosed to stockholders is true.

Special Fiduciary Obligations in Insolvent Companies

The directors' fiduciary obligations do not differ when the corporation is insolvent, but the persons to whom the fiduciary obligations are owed may change. Directors of a solvent corporation generally do not have fiduciary obligations to creditors. When a corporation becomes insolvent, however, the directors stand as trustees of the corporate properties for the benefit of creditors first and stockholders second, and their primary fiduciary obligations accordingly shift from stockholders to creditors.

Special Fiduciary Obligations in Companies 'In Play'

When the sale of “break-up” of a company becomes inevitable, the board has an additional fiduciary obligation to maximize the corporation's value for the stockholders' benefit. The so-called “Revlon duties” charge directors with the duty of selling the corporation at the highest price reasonably attainable.

Liability in Relation to Fiduciary Obligations

The Business Judgment Rule

The business judgment rule is a presumption by the courts that business decisions are made by disinterested directors, on an informed basis and with good-faith belief that the business decision will serve the best interests of the corporation. The practical effect of applying the business judgment rule in a breach of duty case is that the court, without making any inquiry, will assume that a director has complied with his or her fiduciary duties and therefore is not liable. The business judgment rule presumes that directors in making a business decision have met the five elements of the rule. They are as follows:

• The subject of the decision was about business matters of the corporation;
• The director was disinterested, meaning that the director did not have a personal stake in the outcome of the decision and was not subject to influences other than the corporate merit of the subject matter of the decision;
• The director exercised due care by making the decision on an informed basis;
• The director acted in good faith, meaning the director did not make the decision for some purpose other than a genuine attempt to advance corporate welfare; and
• The director did not abuse his or her discretion by making a decision that is not attributable to any rational business purpose.

Unless it is shown that one of these elements was lacking in the decision-making, the court will not substitute its judgment for that of the board of directors. Accordingly, if directors have complied with their fiduciary obligations, they generally will not face liability for business decisions alleged to have injured the corporation or its stockholders.

Independent Review of Directors' Decisions

If criteria for invoking the business judgment rule are not satisfied, the court will independently review the board's decision and determine any liability of the directors for any harm resulting from it. Personal liability for breach of duty of care requires gross negligence, not merely negligent conduct, by directors. In this context, gross negligence means the directors acted with reckless indifference to or in deliberate disregard of the interests of the corporation or its stockholders, or took actions that are outside the bounds of reason.

If a court determines that a director breached his or her duty of loyalty by entering a transaction with the corporation, the director will be liable to the extent the transaction was not fair to the corporation. Fairness in this context means that there was fair dealing in effecting the transaction and that the price of the transaction was fair.

Charter Exculpation

Delaware law authorizes a corporation's certificate of incorporation to contain a provision “eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages” for breach of the fiduciary duty of care. In some states, broader exculpation, including for breach of the duty of loyalty, is permitted.

In Delaware, the scope of exculpation has narrowed, as duty of care claims are sometimes recharacterized as duty of loyalty cases. The courts recently have focused on the duty of good faith, in one case holding that a board could not avail itself of the business judgment rule, because it failed to exercise any business judgment at all respecting negotiation of an executive officer's employment contract and termination.

Liability in Connection with Federal Securities Laws

Applicable Provisions

Subject to a due diligence defense, the Securities Act of 1933 imposes liability on any director of a corporation filing a registration statement making material misstatements or omissions. The Securities Exchange Act of 1934 sets forth, with respect to plaintiff class actions, the criteria for determining the proportionate liability of so-called “covered persons,” including outside directors, and the rights of contribution, if any, of the covered persons. In general, these factors include whether any violation of securities law was knowing; the egregiousness of the person's conduct; and the extent to which it contributed to the plaintiffs' losses.

SEC Enforcement

Recent enforcement actions by the SEC have focused increasingly on the involvement of directors in the preparation of periodic reports containing materially misleading statements or omissions. The SEC has generally targeted inside directors in such cases. However, the expanded responsibilities imposed on outside directors by the Sarbanes-Oxley Act could lead to an increased focus on outside directors in connection with these types of investigations. In the event of an investigation, the SEC may make public a report of the investigation and, if warranted, the SEC can issue cease-and-desist orders or assess civil or criminal penalties against the corporation and the culpable directors and officers. The extent to which a person cooperates with or attempts to hinder an SEC investigation can significantly affect the severity of any penalty.