Directors’ rights, duties, and liabilities

The duty of care. Self-dealing transactions. Domination of subsidiary by parent.

a)Right to Inspect Corporate Records --if done in good faith for purposes germane to his position as dir, this right is absolute.

b)Duty of Care --dirs must exercise the care of an ordinarily prudent and diligent person in a like position, under similar circumstances. There is no liability (absent a conflict of interest, bad faith, illegality, or gross negligence) for errors of judgment (business judgment rule--the rebuttable presumption that action was taken on an informed basis, in good faith and exercising reasonable care), but the dir must have been reasonably diligent before the rule can be invoked (Shlensky )

1)The duty of care requires:

I)Education --a dir should acquire at least a rudimentary understanding of the business of the corporation;

ii)Information --a dir is under a continuing obligation to keep informed about the activities of the corp;

iii)Participation --dirs must “generally monitor” corporate affairs, but need NOT involve themselves in the day-to-day operations; (i.e. they should attend board of dirs meetings with reasonable regularity).

iiii)Inquiry --a dir has a duty to inquire when circumstances would alert a reasonable person for the need of inquiry.

iiiii)Action --where wrongdoing is revealed, a dir should object, correct, or resign. Object to the course of conduct, steer toward correction, and resign if it isn’t corrected.

2)Extent of liability --dirs are personally liable for corporate losses directly resulting from their breach of duty or negligence in falling to discover wrongdoing. a director may seek to avoid being held personally liable for acts of the board by recording his dissent.

I)Many statutes permit the articles to abolish or limit dir’s liability for breach of the duty of care absent bad faith, intentional misconduct, or knowing violation of law.

3)Defenses to liability --these include good faith reliance on management or expert’s reports. Disabilities may be considered in determining whether the dir has met the standard of care.

c)Duty of Loyalty --a catch-all duty designed to prevent unfairness--the duty to act in good faith (BJR applies). Application:

1)Self-dealing transactions

I)Common Law:

(1)early absolute prohibition against self-dealing renders transactions void or voidable;

(2)permissive self-dealing: dirs and officers may contract with the corp if (a)done in “strictest good faith.”; (b)with full disclosure; and (c)consent of “all concerned.”

[1]--burden of proof is on the dir to establish good faith, honesty & fairness;

[2]--courts weigh self-dealing transactions with “closest scrutiny”

(3)self-dealing prohibition also applies to intercorporate transactions where dirs are common.

ii)Statutory (example) :

(1)quasi-safe harbor approach (Iowa statute)--transaction is not void or voidable because of dirs’ interest, if either:

[1]--interest is disclosed and approval is made without counting the vote of the interested dir.

[2]--interest is disclosed to shs and shs authorize

[3]--transaction is fair and reasonable

(2)Note--dir must still establish that he acted in good faith, honesty, and fairness

2)Domination of subsidiary by parent --courts look at the transaction to see if self-dealing has occurred. Example (Sinclair Oil ):

I)declaration of dividends shared pro rata was NOT self-dealing; BJR applies

ii)contract between parent and sub was self-dealing; apply intrinsic fairness test

3)Manager’s compensation :

I)Ordinary corporations --conflicts are inevitable but all firms need to set compensation. The burden of proof is placed on challengers as a matter of convenience.

ii)Close corporations --the income generated by the firm may be diverted to salaries, so there is an option for self-dealing by the parties in control to take tax-advantaged compensation in the form of salaries (taxed once) as opposed to dividends (taxed twice).

d)Statutory Duties and Liabilities --in addition to general duty of care, federal and state laws also impose certain duties and liabilities, e.g., registration requirements under the Securities Act of 1933, liability for rule 10b-5 violations, liability for illegal dividends. Some statutes also impose criminal liability on corporate managers for unlawful corporate actions.