The laws regarding the duties and liabilities of boards of directors are generally governed by state corporate statutes, particularly in the context of private companies.
Boards of directors are generally responsible for the management of the business and affairs of the corporation. It is tempting to think of that responsibility as belonging to company management, but it is ultimately the board’s duty to oversee, and it is also ultimately their liability for breaches of those duties.
In connection with the various responsibilities that a director has, every director owes fiduciary duties to the corporation, which are commonly broken down as the Duty of Care and the Duty of Loyalty, as well as other duties commonly viewed as standing alone. Generally, intentional breaches of those duties can give rise to potential personal liability of the director. A corporation may generally indemnify a director from any such personal liability as long as the person acted in good faith and in a manner reasonably believed to be in or not opposed to the best interests of the corporation. A corporation must indemnify a director if that director is successful on the merits in defending against a claim. A separate indemnification agreement negotiated between the director and the corporation can provide a director with additional indemnification rights as long as those grants do not contravene state law. To further secure a corporation’s indemnification obligations, the corporation may obtain directors’ and officers’ liability insurance.
A. Duties Imposed Upon Directors
Every director of a corporation owes fiduciary duties to the corporation for which he or she serves and to its stockholders. Directors can be subject to personal liability for breaches of these duties; as such, it is important for directors to understand what is required with respect to their fiduciary duties. Directors’ fiduciary duties are primarily regulated by the statutory law (and the associated case law) of the state in which the corporation is incorporated. For purposes of this blog, we will focus on Delaware law.
In connection with the power to manage the operations of the corporation, directors in Delaware owe two core fiduciary duties to the corporation and its stockholders – the duty of care and the duty of loyalty.
- Duty of Care Directors must satisfy the duty of care when making decisions or acting on behalf of the corporation. That duty of care is generally expressed as the obligation to use the amount of care which an ordinarily careful and prudent person would use in similar circumstances.In discharging his or her duty of care, a director should act (i) in good faith, (ii) on an informed basis, and (iii) in the honest belief that the actions being taken are in the best interests of the corporation. A director is not presumed to have special management skills but is expected to exercise common sense and apply the skills he or she possesses.
- Duty of Loyalty A director owes the corporation on whose board he or she sits and its stockholders a duty of loyalty to give higher priority to the interests of the corporation and its stockholders than to such director’s own personal interests in making business decisions. Essentially, the duty of loyalty requires that the best interests of the corporation and its stockholders take precedence over any interest possessed by a director, officer or controlling stockholder and not shared by stockholders generally.The duty of loyalty can be breached either by making a self-interested transaction or taking advantage for personal gain a business opportunity otherwise available to the corporation.
- Other Duties While the duty of care and the duty of loyalty are the core duties owed to a corporation by the director, there are a number of components of these duties that have been recognized as stand-alone duties, such as a Duty of Candor or disclosure, which derives from both the duty of care and duty of loyalty. The duty of candor calls upon directors to communicate honestly and to make a full and fair disclosure to their fellow directors and the corporation’s stockholders of all information known to them that is relevant to the decision under consideration. In judging whether a director has satisfied his or her duty of candor, courts will examine the possible impact on the board’s decision of the information that the director did not disclose or only partially disclosed.As the board of directors is charged with overseeing the management of the corporation, a duty of oversight has also been recognized, which requires the board to have a functioning oversight and compliance system in place. Directors can be subject to liability for a breach of this duty if they fail to implement any reporting system or controls or to monitor the reporting system that is in place, thereby preventing themselves from learning of any risks uncovered by such reporting system.
B. Potential Personal Liability of Directors
Directors of a corporation may be subject to personal liability for acts performed as a director. These liabilities can be divided into two types: liabilities for which the corporation may indemnify the director and those liabilities for which indemnity is not available.
Actions that may be indemnified include all actions taken in good faith on behalf of the corporation as a director.
Examples of liabilities that generally cannot be indemnified (unless the director is successful on the merits in defense of such a claim) include:
- Intentional breach of the duty of care to the corporation.
- Intentional breach of the duty of loyalty to the corporation.
- Misappropriation of a corporate asset for personal use.
- Commingling of personal and business assets.
- Failure to disclose a potential or actual conflict of interest.
- Crimes against the corporation.
C. Limitation of Liability of Directors
The potential liabilities of directors can be limited by indemnification provisions in the corporation’s certificate of incorporation and bylaws, by a separate indemnification agreement between the corporation and the director, and by obtaining directors’ and officers’ liability insurance.
- Indemnification of Directors – Summary of Delaware Law Delaware law, in Section 145 of the Delaware General Corporation Law, sets forth the state’s corporate indemnification legislation. The following is a summary of Delaware corporation law on the indemnification of directors.Delaware law (section 145(c)) requires that a corporation indemnify its directors as to the expenses or liability they incur in connection with or as a result of any lawsuit or administrative or criminal proceeding in which those directors succeed on the merits of the suit or proceeding. Delaware law (sections 145(a) and (b)) generally permits a corporation to indemnify its directors as to the expenses or liabilities they incur with respect to any lawsuit or proceeding in which those directors do not succeed on the merits so long as those directors acted in good faith and in a manner reasonably believed not to be inconsistent with the corporation’s best interests.A corporation may also agree – either in agreements with specific directors or generally in its Articles or Bylaws – to indemnify its directors for all expenses and liabilities that, under Delaware law as discussed above, are considered permissibly indemnifiable. (Section 145(f).) In effect, such agreements or provisions convert expenses and liabilities that are permissibly indemnifiable into mandatorily indemnifiable expenses and liabilities. Further, as long as certain requirements are met, a corporation may advance to a director the funds needed to defend himself or herself in any civil or criminal proceeding or investigation, subject to repayment by the director in the event that indemnification is ultimately determined to be unwarranted. (Section 145(e).)
Thus, Delaware law generally provides that a director who succeeds on the merits of a proceeding brought against him by virtue of his serving as a director is entitled to mandatory indemnification. A director who is unsuccessful in such a proceeding still may have permissible indemnification rights if he can prove that he acted with the requisite good faith (or, in the criminal context, without knowledge that his acts were unlawful).
Thus, the indemnification statute allows for a broad range of indemnification by the corporation, including expenses in defense of a claim.
- Separate Indemnification Agreements As noted above, Section 145(f) of the Delaware General Corporation Law allows corporations to craft additional indemnification rights beyond the state statute as long as those additional grants do not contravene Delaware law.
- D&O Insurance To further secure the corporation’s indemnification obligations, the corporation should obtain directors’ and officers’ liability insurance (“D&O Insurance”). D&O Insurance is crucial because it may be the only shield between a director’s personal assets and substantial liability.