This is Part 3 (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 Part 2 of this post, I continued 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 this Part 3 of the post, I will describe specific means of limiting personal liability of directors for decisions they make in good faith.
How can directors protect themselves?
It is unrealistic to say that directors can protect themselves against personal liability simply by exercising due care at all times when acting on company business. This is because a disgruntled shareholder can make life miserable for a director simply by filing a claim against him or her, regardless of whether it has merit. Further, when a claim is based on allegations of a failure to exercise due care, the litigation usually is fact intensive, which means that it is difficult for the defendant (i.e., the director) to defeat the claim in early stages of the litigation.
If the directors believe that a particular board action might expose them to risk of a claim that they breached their duty of due care, they could attempt to protect themselves by requiring the action to be approved by the shareholders, but this is a poor option in most instances.
First, such a process would be cumbersome, especially if used often. Second, it would not lead to a better business decision because it would remove the matter from the discretion of the directors, who are the most qualified decision makers and who have a duty to act in the company's best interest, and would grant that discretion to shareholders, who may not be qualified to make such decisions and who have no duty to act in the company's best interest. Third, even if the shareholders approved the action, a shareholder could later bring a claim against the directors based on an allegation that the directors did not use due care in fully informing the shareholders of facts or risks that the shareholders needed in order to make a proper decision.
For more effective protection against personal liability, therefore, the directors need the corporation to act.
How can the corporation protect directors?
Your family-owned corporation can adopt provisions in its governing documents to protect the directors against personal liability for actions they take in good faith, and it can fund those protections with insurance.
Under the laws of most states, a corporation's articles of incorporation (a/k/a/ "charter") can exculpate directors from liability for decisions they make in good faith. Exculpation, in this context, operates like an advance waiver of claims by the corporation and its shareholders.
When properly applied, exculpation does not eliminate a director's duty of due care, but it waives the rights of the corporation or a shareholder from attempting to hold a director personally liable for breaching his or her duty of due care. Presumably, notwithstanding exculpation as to a director's personal liability, if a director breached his or her duty to exercise due care, then the corporation or shareholders could seek other judicial remedies, such as preventing a board decision from being implemented or nullifying or reversing a board action.
Note that a corporation's ability to use exculpation for claims based on a director's breach of the duty of loyalty is much more limited than for a director's breach of the duty of due care. As mentioned in Part 2 of this post, the law generally views a breach of the duty of loyalty to be worse than a breach of the duty of due care. In some instances, however, corporation documents may expressly permit specific activity that might otherwise be deemed to be a breach of loyalty, such as specific types of transactions between the corporation and a director. This can be especially helpful in a family business, in which apparent conflicts of interest might be more common (and more acceptable) than in businesses whose owners are not related.
Further, under the laws of some states, the governing documents of a limited liability company (as opposed to a corporation) may waive all duties of due care and loyalty that might otherwise be imposed on the LLC's managers (or directors), leaving only a duty of good faith and fair dealing with respect to how the managers (or directors) apply the provisions of the LLC's operating agreement.
● Indemnification and Advances.
A corporation's documents can indemnify directors by providing that the corporation will pay any losses that the director might incur as a result of a claim against the director for actions that the director took in good faith. Such indemnification should include the cost of attorneys' fees incurred by the director as a defendant against such claims, as well as any judgment awarded against the director.
To be truly effective, an indemnification provision should allow the director to obtain an advance from the corporation for the payment of attorneys' fees, as those fees are incurred, as long as the director undertakes to return the advance if it is determined that he or she did not act in good faith.
Director indemnifications can be funded through D&O (directors and officers) insurance coverage. Like most other forms of business insurance, the coverage should be tailored to fit the risk and the circumstances under which the claims for coverage might arise. For example, the language in the policy describing the coverage should be substantially similar to the language in the corporation's governing documents describing the substance and mechanics of the indemnification.
● Limit Derivative Actions.
A corporation's governing documents can contain provisions limiting circumstances under which a shareholder may cause the corporation to bring a claim against a director through a derivative action. (See Part 2 of this post for an explanation of derivative actions.) Further, by transferring shares to next generation owners in trust (rather than outright), senior generation owners of a family business can help control who would make the decision to exercise a shareholder's rights to pursue a derivative action. If the shares are held in trust, then the trustee or other trust fiduciary, rather than the beneficial owners, would decide whether or not to bring claims against directors. These measures may prevent an unsophisticated or mercurial family member from having the power to commence shareholder litigation.
● Power to Expel.
A corporation's governing documents or shareholders' agreements may allow the shareholders to vote to expel a shareholder who has become disruptive (for example, by threatening lawsuits against the directors). An expulsion clause might provide for the corporation or the other shareholders to purchase the expelled shareholder's stock at fair market value and on terms that are fair to the seller.
It is appropriate for your family business and its owners to expect to hold directors to account when they knowingly and purposely harm the business, especially when they do so to serve their own personal interests. However, if you want to assemble a quality board for your family business and encourage the board to act on its best business judgment, then you should consider adopting means described above to protect the directors against personal liability for decisions they make in good faith.