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Care, loyalty and lawsuits: Fiduciary duties of directors

Let’s start with a hypothetical scenario: A friend of yours, the co-owner of a small L.A. based enterprise that produces custom made furniture, asks you to join his company’s Board of Directors. You feel honored by the trust placed in you, don’t see any potential conflict of interest, reflect on what the time commitment might be — a few board meetings a year doesn’t sound too bad — and are about to say yes. But then you have second thoughts: What would you be getting yourself into in terms of liability? If something went wrong with the company, could you be held accountable in a lawsuit?

The short answer is yes. While the Board of Directors, rather than running the day-to-day business of a company, basically sets the managerial tone, its members do owe two major fiduciary duties to the corporation and its shareholders; they are the duty of care and the duty of loyalty. The duty of loyalty requires directors to act without personal economic conflict and to put the company’s interests before their own. (I will address this topic in more detail in another post.) The duty of care requires that the directors act in good faith and use the same care as a reasonably prudent person in their position and circumstances would.

Lawsuits alleging a violation of the duty of care aren’t uncommon, but in many cases directors are protected by a principle called business judgment rule. It effectively prevents shareholders and courts from second-guessing board decisions, so as to allow the directors wide latitude in how they act for the benefit of a business. For a lawsuit to be successful, plaintiffs must prove that the business judgment rule doesn’t apply, e.g. because the directors acted in a way that was illegal or fraudulent, or because they made an irrational or an uninformed decision, or because their decision lacked business justification.

Back to the hypothetical scenario above, involving you and your friend’s furniture company. Before agreeing to a possible board position, you’d probably do well to inform yourself about the business, its policies, and the other directors and major stakeholders. Obviously, you should also have a good, detailed understanding of the fiduciary duties required of you and of the obligations you’d face — because holding the position of a director is much more than a time commitment.

By Kevin J. Moore