A Primer On Fiduciary Obligations Of Directors And Officers

Directors and officers are deemed fiduciaries because they stand in a position of trust and confidence to their corporation. Being a fiduciary means that the directors and officers are bound to act reasonably and in good faith and for the benefit of their corporation and its shareholders. Accordingly, directors and officers are forbidden to use their positions to obtain personal gain at the expense or to the detriment of their corporation.

The question of the directors’ or officers’ liability for breaching this fiduciary duty arises in the following contexts:

  1. Should a director be liable for corporate losses due to a decision of the board of directors?
  2. May a director contract with his or her corporation?
  3. Directors’ or officers’ receipt or approval of excessive compensation.
  4. Directors’ use of corporate stock or assets to retain control. and
  5. May a director or officer acquire property or a business opportunity which is of interest to the corporation?

Directors’ Liability for Losses Flowing from their Decisions

Directors do not guarantee the profitability or eventual success of their business decisions. The phrase is often repeated that the directors are not liable for losses incurred as a result of the directors’ good faith business judgment arrived at through the exercise of reasonable care. This is the so-called business judgment rule which protects the directors from liability for losses resulting from their corporate decisions.

When the board of directors has arrived at a decision which is a good faith business judgment, courts ordinarily will not supplant the directors’ decision with the court’s determination of what should have been the proper decision. The court’s inquiry is limited to determining whether the directors’ decision is protected by the business judgment rule. If satisfied it is a good faith and

reasonable business judgment, the courts will uphold the decision and dismiss the action. If, on the other hand, it is determined that the directors acted negligently or in bad faith, the directors will not be protected by the business judgment rule.

Observe that the application of the business judgment rule is conditioned upon the directors (a) acting in good faith and (b) with reasonable care. The requirement that the directors act in good faith is usually referred to as the directors’ duty of loyalty. The director’s duty of loyalty requires that the director serve the broad interests of the corporation when acting in his corporate capacity. Accordingly, the director is prohibited from serving his own personal interests at the expense or the detriment of the corporation. Hence, a breach of the director’s duty of loyalty removes the director’s actions from the protection of the business judgment rule.

A breach of the directors’ duty of care is another basis for removing their decisions from the protections of the business judgment rule. The duty of care requires that each director discharge his duties with the degree of diligence, care and skill which the ordinarily prudent person would be expected to exercise under similar circumstances. This is, of course, a question of fact. The standard is applied to each individual director’s actions, so that it is possible that some but not all the directors may be deemed to be negligent.

Corporate Contracts in Which its Director is Deemed Interested

The “interested director” issue arises when (a) a director contracts with his corporation; or (b) the corporation contracts with a partnership in which the director is associated; or (c) the corporation contracts with another corporation in which the director is an officer, director or substantial shareholder.

At early common law, any contract in which the director was interested was voidable at the option of the corporation because of the director’s interest. Today, in Alabama, the corporation’s contract with an interested director will not be voidable solely because of the director’s interest, provided one of the following requirements is satisfied:

(a) If the director’s interest is disclosed and approved by a majority of the disinterested directors attending the meeting, the contract is not voidable because of the director’s interest.

(b) If the director’s interest is disclosed to the shareholders and those owning a majority of the voting shares approve the transaction, the contract will not be voidable because of the director’s interest.

(c) If the contract is fair and reasonable to the corporation (i.e., it does not result in the corporation giving up more than it received), the director’s interest will not void the contract.

Not all the above requirements must be met to prevent the contract from being voidable. Satisfaction of any one of the three grounds listed above is sufficient. Moreover, the satisfaction of one of the above requirements merely prevents the contract from being deemed voidable solely because of the director’s interest therein.

Stating this somewhat differently, failure to comply with any of the above requirements makes the contract automatically voidable, without proof of actual wrongdoing by the interested director. But, even if there has been satisfaction of one of these requirements, the contract may be voided and the director held liable if the director has breached his duty of loyalty to the corporation in connection with the contract.

Therefore, inquiry should always be made as to (i) whether there has been compliance with at least one of the three requirements and (ii) whether the contract should be voided and liability imposed because the director breached his duty of loyalty. As stated above, a director breaches his duty of loyalty when he intentionally acts out of his own personal interests and to the detriment of his corporation.

Corporate officers (e.g., president or secretary) are fiduciaries and must always act in good faith when contracting with their corporation. They may not obtain a “secret” profit on contracts made with their corporation. They must disclose all gains they will make. Furthermore, officers must disclose all facts which are pertinent to the corporation’s decision to enter into the contract with the officer.

The courts will scrutinize a transaction between an interested director or officer and the corporation to see that no advantage was taken of the corporation, its shareholders or creditors. The burden of showing the fairness of the contract or transaction is upon the director or officer asserting its validity.

When a disinterested majority of the corporation’s directors approve the transaction after full disclosure to the board, the business judgment rule applies and the transaction is presumed fair.

Contracts between officers and the corporation, or between directors and the corporation, which are shown to be unfair, or in breach of the fiduciary relationship, are voidable at the election of the corporation. Directors and officers who have breached their fiduciary obligations will be liable to the corporation for damages.

Executive Compensation

Directors are not entitled to compensation or salary for performing the usual and ordinary duties of their office, unless compensation is authorized by the articles of incorporation, bylaws or a resolution of the board of directors in advance of the services being rendered. Compensation arrangements for directors passed by the board of directors are valid, unless the amounts are unreasonable or were approved in bad faith. Retroactive bonuses for directors and officers are void.

A corporate officer si entitled to be paid a fair and reasonable salary for services rendered. Anything over and above reasonable compensation will be construed as a gift which may be attacked by shareholders. However, because of the business judgment rule the board of directors has a great deal of discretion in determining matters of compensation for officers.

Compensation for officers must be arranged in advance of the performance of services; additional salaries for past services will not be upheld in the absence of an implied promise of compensation. Retroactive bonuses are viewed as a “waste of corporate assets” since they are without consideration moving to the corporation.

In assessing whether the compensation plan complies with the above-described standards, the courts defer to the decision of the board of directors, provided the directors exercised a good faith and reasonable business judgment.

Use of Corporate Assets to Retain Control

This concept is best understood through a discussion of the legal issues presented in the following example: Swallowup is seeking to gain control of Acme Corporation by acquiring Acme’s stock. Acme presently has outstanding 1,000 shares of its common stock of which 400 shares are owned by the present members of Acme’s board of directors. To frustrate Swallowup’s bid for control, the directors resolve that Acme acquire 300 of its own shares. This is accomplished. Thus, with only 700 shares outstanding of which 400 are owned by the present board, Swallowup’s threat is removed. Have the directors misused their position and, therefore, become liable for any harm proximately caused? Directors may use corporate assets to prevent a change in control, provided the directors have made a reasonable and good faith business judgment that the defensive maneuver is in the best interests of the corporation. Defensive tactics are justified, for example, if Swallowup were reasonably perceived to be a corporate looter who once in control would have wasted Acme’s assets.

Usurpation of Corporate Opportunity

A director or officer may engage in outside business activities, such as by making personal acquisitions, provided such undertakings do not amount to usurpation of a corporate opportunity. A corporate opportunity is usurped when the corporation has an interest or expectancy in the business transaction undertaken. Many factors are considered in determining whether the corporation had an interest or expectancy in the transaction, although all of these factors need not be present to establish that there has been usurpation of the corporate opportunity.

When the transaction involves the type of business in which the corporation engages, or the property acquired of a character which the corporation would desire for expansion, there is a strong case for finding a usurpation of the corporate opportunity. If, however, the corporation is not financially able to undertake the transaction or to acquire the property, a strong case can be made that the corporate opportunity is not usurped.

If the director or officer discovers the opportunity while acting in a corporate capacity (e.g., business trip for corporation) and not while acting in his own personal capacity, this is a strong factor for concluding that he has usurped a corporate opportunity. And, if the officer or director used corporate funds to purchase property, the court will impose a constructive trust in favor of the corporation.

If the corporation has previously considered and rejected the opportunity, or one quite similar to it, the corporation no longer has an interest or expectancy in it. However, this rejection must have been by a disinterested majority of the directors.

The Alabama State Bar requires the following disclosure: No representation is made that the quality of legal services to be performed is greater than the quality of legal services performed by other lawyers.

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