If you wish to attract and retain quality directors to serve on the governing board of your family business, and if you want the board to be confident that it can act on its best business judgment in all instances, then your business should adopt measures to protect directors against personal liability for actions they take in good faith. This is especially important at times like the present, when the board must confront all the business challenges created by COVID-19, the related economic disruption, the need to change business models, and the opportunities or imperatives arising out of new technologies.
In Part 1 of this post, I will introduce the topic of limiting director liability and describe the functions of a governing board. (In a future post, I hope to make the case for why most family businesses should have a governing board, including one or more independent directors.) In Part 2 of this post, I will describe the standards of conduct that apply to directors and how those standards can give rise to personal liability. In Part 3 of this post, I will describe specific means of limiting personal liability of directors.
My comments on this topic are written in the context of a business organized as a corporation, but limited liability companies also can have a governing board (of "managers" or directors). If the primary business entity in your family business is an LLC, you can adapt the measures discussed in Part 3 of this post to apply them to a governing board under applicable LLC statutes and related court decisions in the jurisdiction that applies to your LLC's internal affairs.
Why is Director Liability a Problem?
If a director purposely abuses his or her power for personal gain, to the detriment of the corporation, then the director should be held to account and should be required to personally compensate the corporation or its owners for the related damages.
Under some legal doctrines, however, a director could be held personally liable for losses that the corporation suffers as a result of decisions that the director made in good faith, if such decisions appear to be imprudent or careless. Such instances may include decisions to rely upon information that is later deemed unreliable or to delegate authority to individuals who are later deemed to be incompetent or untrustworthy. Such instances also may include a director's failure to act.
The threat of personal liability for mistakes made in good faith may impair a director's ability to make good decisions. Business success requires risk. Sometimes, greater rewards require greater risks. Often a governing board is required to balance risk and reward or to sacrifice short term benefits for potential long term success. If the shareholders can, in effect, use director liability as a means to shift the risk of business decisions from the owners to the directors, then the directors may govern too conservatively and may be overly concerned about maintaining a dazzling short-term record.
In addition, a disgruntled shareholder can weaponize director liability to exert improper pressure on the board or even to exact revenge against a particular director based on a personal grudge. Theoretically, a shareholder can bring suit against a director on the shareholder's own behalf (a "direct" action) or on behalf of the corporation (a "derivative" action). A director who is intimidated by the threat of incurring personal liability under such claims may make decisions based on distorted priorities, may decline to make controversial or tough business decisions, or may withdraw from serving on the board altogether.
What is the Function of a Governing Board?
To put the issue of director liability in the proper context, first consider the function of a governing board, as described in applicable statutes. The corporation statutes of many states are based on the American Bar Association's Model Business Corporation Act (the "Model Act"). Here's a link to the Model Act, including official comments:
Under the Model Act, "[A]ll corporate powers shall be exercised by or under the authority of the board of directors, and the business and affairs of the corporation shall be managed by or under the direction, and subject to the oversight, of the board of directors." Model Act s. 8.01(b).
The board usually has power to issue shares of stock and declare cash dividends. The board usually does not manage the day-to-day affairs of the business, but rather the board delegates operational management to executive officers and other professional managers. This does not, however, "relieve the board of directors from its responsibility to oversee the business and affairs of the corporation…." Model Act s. 8.01(b) (comment).
The board's responsibilities include oversight of the following: business performance, plans and strategy; management’s assessment of major risks; performance and compensation of executive officers; policies and practices to comply with law and ethical conduct; management’s preparation of budgets and financial statements; management’s design and assessment of internal controls; plans for the succession of the CEO and other executive officers; and management's design and use of information and reporting systems. See, Model Act s. 8.01(b) (comment).
Although directors are elected by the shareholders, the directors are expected to exercise their own business judgment and not to act simply as a rubber stamp for the dictates of the shareholders (or any one of them). "The [Model] Act’s broad grant of authority and responsibility to the board of directors constitutes the rejection of the concept that the directors, having been elected by the shareholders, merely serve as agents to implement the will of the shareholders." Model Act s. 8.01(b) (comment).
Please return to my blog next week for Part 2 of this post, in which I will discuss the standards of conduct that apply to directors as they pursue the board's function and how these standards give rise to a director's risk of personal liability.