Directors & Shareholders – their rights & responsibilities towards each other & the company

The owners of a corporation are its shareholders. They invest capital, receive voting rights over certain matters, and receive dividends and residual claim on the company’s assets. Directors are elected by the shareholders to manage the company. Then directors, not shareholders, hire and monitor the executives. Executives can serve as directors at the same time, but usually majority of the board consist from non-executives. Executives run day-to-day operations of the company while directors overview the business and make strategic decisions of major points. Both directors and executives own fiduciary duties to the corporation. Shareholders usually do not own fiduciary duties either to the company or to each other with some exceptions, which we review later in this article. 

 

Directors and executives own fiduciary duties to the company and its shareholders because they are in the position to run the business and exercise control over commercial operations. Of course, in small companies usually shareholders serve as directors and officers at the same time, but once the business grows these roles may become separated. Since the shareholders are the ultimate beneficial owners of the corporation, their interests must be the primary driver for whoever is placed in charge. It was long held by the courts that in a traditional for profit corporation shareholder wealth maximization is the main objective of the directors and all decisions must be made guided by this principle.

 

As earlier said, directors own fiduciary duties to the company – a duty of care (“use care and skill of ordinary prudent people in a similar position”), a duty of loyalty (not to usurp corporate opportunity) and a duty of good faith. When courts review whether directors carried out their fiduciary duties prudently, the used standard of review is business judgment rule.  The focus is on the process of decision-making, not substance. Substance only reviewable if the decision was irrational or they committed a waste. The directors cannot be punished for a decision, which didn’t work out as planned if they acted in good faith and in the honest belief that the action taken was in the best interests of the company based on the information they had and existent circumstances. This is called business judgment rule. It can be overcome only raising a duty of loyalty or duty of care violation. In Kamin v. Amex the court held that “To allege that a director negligently [acted] without alleging fraud, dishonesty or nonfeasance [failure to inform oneself] is to state merely that a decision was made with which one disagrees”. It further stated that business decisions must be made in a boardroom, not in a courtroom. The court only reviews whether the violation of legally imposed duties took place.

 

Let’s review each legal duty of the directors and applicable standards of review.

 

DUTY OF CARE

 

Duty of care states that each director must act on the informed basis. Cannot be ignorant, close eyes on some matters or not have ordinary understanding of the business. The violation of duty of care is procedural, not substantive. When determining whether there was a violation the following is considered – how the director arrived to a decision, what documents he reviewed, was inquiries he made, the length of the board meeting and who was present, and all other matters that may be relevant to the decision-making process.

 

DUTY OF LOYALTY

 

Means no self-dealing, no taking a corporate opportunity, no entrenchment.

 

If there’s a possibility of self-dealing, the business judgment rule is overcome and the test becomes fairness (whether the deal is fair to the corporation). If a board wants to avoid fairness review, they can make all necessary disclosures about interest of a party and put it out for a shareholder voting. Then only disinterested shareholders must vote.

 

When the court reviews whether a director took a corporate opportunity for his personal benefit, the following it considered:

 

·         Was a company financially able to use the opportunity?

·         Was it in the company’s line of business?

·         Could the company have expectancy or interest in it?

·         Would a use of the opportunity by the director create a conflict of interest?

 

DUTY OF GOOD FAITH

 

Good faith covers subjective bad intent that isn’t self-dealing and conscious disregard of one’s duties.  One of the duties a person can consciously disregard is a duty of care and a part of the duty of care is a duty of oversight.  So if a director is conscious of his negligence (including his failure to establish or maintain an oversight system which requires such nonfeasance that courts will assume it was a conscious failure), a director has acted in bad faith.  The test to prove bad faith is  “complete and utter”, though it seems that courts will be more likely to find “complete and utter” in monitoring cases than in bad decision-making process cases.

 

In re Caremark the court held that the board has a duty to monitor to some extent. This duty can be violated by either  

 

·         Failure to install a monitoring system, or

·         Sustained failure to exercise oversight

 

Part of directors’ duty of care is to have a system through which they can monitor things like legal compliance, for example.  

 

Corporate charter may include provision “eliminating or limiting personal liability of a director … for monetary damages for breach of fiduciary duty as director, provided”, no exculpation for (i) duty of loyalty breaches, (ii) acts not in good faith, involving intentional misconduct or violations of law.  

 

The duties of majority shareholders

 

Generally, shareholders owe no duties to one another. But when shareholder controls director (e.g., through an employment relationship), that control subjects the shareholder to director’s duties to other shareholders. Additionally, controlling shareholders may owe certain duties to minority shareholders. If transaction raises self-dealing possibility and shareholder is a “controlling shareholder”, then transaction subject to “fairness” review (regardless of ratification).

 

A claim against a controlling shareholder can be stated only if there was self-dealing/corporate opportunity.  Then the test is fairness to the company.  Ratification by disinterested shareholders or directors only shifts the burden of proof from controlling shareholder or director to the plaintiff regarding the fairness of it, but the test remains the same is - was it fair to the company?

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