This is Part 2 (of 3) of a post about how you can better attract and retain quality directors for the governing board of your family business if you protect them against personal liability for decisions they make in good faith. By limiting the liability of directors, you also can help ensure that the board is free to make tough business decisions and to govern the business for long term success, rather than short term payoffs. Having a good governing board that is empowered to act on its best judgment is especially important in these challenging times.
In Part 1 of this post, I introduced the topic of limiting director liability, and I began to create a context for the discussion by describing the functions of a governing board. In this Part 2 of the post, I will continue to develop that context by describing 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 for decisions they make in good faith.
What is a Director's Standard of Conduct?
Broadly, a director must act with due care and with loyalty toward the corporation. These standards are expressed in different ways under the statutes and common law of many states, but the following descriptions are consistent with most state law:
◊ The duty of "due care" requires a director to be make informed decisions using the care that a person in like position "would reasonably believe to be appropriate." Model Act s. 8.30(b) (comment 2).
◊ The duty of "loyalty" requires a director to act in the best interests of the corporation. This includes the duty to fulfill the director's responsibilities and exercise the director's authority in good faith.
In some cases, a director's utter failure to put effort into performing his or her role may be deemed a breach of the duty of loyalty. More, often, however, courts find that a director has breached the duty of loyalty when he or she has a conflict of interest and has pursued the director's personal interests ahead of those of the corporation or otherwise has derived an unfair benefit from the corporation.
Some state statutes or court decisions have charged directors with a duty of loyalty not just toward the corporation but also toward the shareholders, collectively. Further, in some instances of corporate insolvency, some statues or courts would impose on directors a duty to protect the interests of the corporation's creditors, rather than its shareholders.
When considering the personal liability of a director, the law usually has viewed a breach of a director's duty of loyalty to be worse than a breach of a director's duty of due care. In fact, the law is reluctant to impose personal liability on a director for activity that might be deemed a failure of due care, because it would discourage governing boards from taking necessary business risks or trading off short term benefits for long term goals.
"Boards of directors and corporate managers make numerous decisions that involve the balancing of risks and benefits for the enterprise. Although some decisions turn out to have been unwise or the result of a mistake of judgment, it is not reasonable to impose liability for an informed decision made in good faith which with the benefit of hindsight turns out to be wrong or unwise." Model Act s. 8.31 (comment).
How is Personal Liability Imposed on Directors?
Usually, personal liability is imposed on a director through a lawsuit brought against the director by one or more shareholders or by the corporation, under the direction of other directors or successor directors. When a shareholder brings a legal action against a director, it is either a "direct" action or a "derivative" action.
In a direct action, a shareholder asserts that the director's decisions, activity, or omissions caused loss or damages to the shareholder, individually and apart from the effect on the corporation. For example, if the board used excess revenue to pay bonuses to shareholder-employees, rather than pay dividends, then a shareholder who is not an employee might argue that he or she was harmed by that decision, even though it did not harm the corporation.
In a derivative action, a shareholder asserts that the director's decisions, activity, or omissions caused loss or damages to the corporation, and thus the shareholder's interest was harmed indirectly. For example, if the board authorized the company to sell assets for less than fair market value, the corporation might be harmed by a loss of value, which could indirectly harm the shareholder by reducing the value of the corporation's shares. In a derivative action, therefore, the shareholder represents the interests of the corporation, even if the shareholder is not otherwise an agent of the corporation.
These mechanisms provide a disgruntled shareholder with a broad range of litigation tools with which to penalize directors, especially if the shareholder can attempt to impose, or threaten to impose, liability on directors even when the directors act in good faith.
To illustrate, using the first example cited above, it is possible that the board decided in good faith that payment of bonuses to the shareholder-employees was necessary to compensate them at a market rate. Similarly, in the second example, it is possible that the board determined in good faith that the purchase price for the assets was not below fair market value.
In each instance, the board may have made its decision based on poor advice (e.g., from an officer, a compensation consultant, or an appraiser), but the board may have relied on that advice in good faith. If a shareholder is allowed to recover for a claim based on a director's failure to exercise "due care," then the directors could be held personally liable for these decisions, even though they were trying to act in the corporation's best interests and even if they derived no personal benefit from their actions.
Most qualified directors will accept the idea that they can be held to account if they knowingly abuse their position on the board for personal gain, but they will not want to serve as directors if they can be held personally liable for mistakes they make when they are honestly trying to do the right thing for the corporation.
In Part 3 of this post, I will write about how you can use legal, market, and procedural means to prevent the directors of your family business from incurring personal liability for actions taken in good faith.