Board of Directors

In relation to a company, a director is an officer (that is, someone who works for the company) charged with the conduct and management of its affairs. A director may be an inside director (a director who is also an officer or promoter or both) or an outside, or independent, director. The directors collectively are referred to as a board of directors. Sometimes the board will appoint one of its members to be the chair of the board of directors.

Theoretically, the control of a company is divided between two bodies: the board of directors, and the shareholders in general meeting. In practice, the amount of power exercised by the board varies with the type of company. In small private companies, the directors and the shareholders will normally be the same people, and thus there is no real division of power. In large public companies, the board tends to exercise more of a supervisory role, and individual responsibility and management tends to be delegated downward to individual professional executive directors (such as a finance director or a marketing director) who deal with particular areas of the company's affairs.

Another feature of boards of directors in large public companies is that the board tends to have more de facto power. Between the practice of institutional shareholders (such as pension funds and banks) granting proxies to the board to vote their shares at general meetings and the large numbers of shareholders involved, the board can comprise a voting bloc that is difficult to overcome. However, there have been moves recently to try and increase shareholder activism amongst both institutional investors and individuals with small shareholdings.

Because directors exercise control and management over the company, but companies are run (in theory at least) for the benefit of the shareholders, the law imposes strict duties on directors in relation to the exercise of their duties. The duties imposed upon directors are fiduciary duties, similar in nature to those that the law imposes on those in similar positions of trust: agents and trustees.  In relation to director's duties generally, two points should be noted:

the duties of the directors are several (as opposed to the exercise by the directors of their powers, which must be done jointly); and
the duties are owed to the company itself, and not to any other entity.  This doesn't mean that directors can never stand in a fiduciary relationship to the individual shareholders; they may well have such a duty in certain circumstances.

Business Judgment Rule

The business judgment rule is a case law-derived concept in Corporations law whereby a court will refuse to review the actions of a corporation's board of directors in managing the corporation unless there is some allegation of conduct that (1) violates (a) the directors' duty of care, (b) duty of loyalty, or (c) duty of good faith; or (2) that the decisions of the directors lacks a rational basis. Courts often analyze the rational basis requirement as part of the director's duty of good faith. (It remains unclear whether the duty of good faith is a separate duty. The Delaware Supreme Court's decision in Disney did not clarify the issue.)

In effect, the business judgment rule creates a strong presumption in favor of the Board of Directors of a corporation, freeing its members from possible liability for decisions that result in harm to the corporation. In short, it exists so that a Board will not suffer legal action simply from a bad decision. As the Delaware Supreme Court has said, a court "will not substitute its own notions of what is or is not sound business judgment" (Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)) if "the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company." (Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971))

The rationale for the rule is the recognition by courts that, in the inherently risky environment of business, Boards of Directors need to be free to take risks without a constant fear of lawsuits affecting their judgment. See, for instance, Gagliardi v. TriFoods Int’l Inc., 683 A.2d 1049, 1052 (Del. Ch. 1996) (setting out rationale for the rule).

The presumption raised by the Business Judgment Rule may be rebutted by the plaintiff. Rebuttal typically requires a showing that the defendants violated duty of loyalty, care, or good faith. If the plaintiff can show that an action should not be protected by the business judgment rule (such as for violation of duty of loyalty or care), then the burden will shift to the defendant to show that the action meets the higher burden of entire fairness.

In addition, even if there is no duty violation, acts constituting waste are not protected by the business judgment rule.

Some Board decisions lie outside the business judgment rule. For instance, in the takeover context, courts will apply the more stringent Unocal test, also called intermediate scrutiny.

Example.

The following test was constructed in the opinion for Grobow v Ross Perot 539 A.2d 180, Del. 1988, as a guideline for satisfaction of the business judgment rule. Directors in a business should:

1. not involve self-interest
2. act on an informed basis
3. act in good faith
4. act in the best interests of the corporation

Fiduciary Responsibilites

The fiduciary duties of directors reflect the expectation of corporate stakeholders regarding oversight of corporate affairs. The basic fiduciary duty of care principle, which requires a director to act in good faith with the care an ordinarily prudent person would exercise under similar circumstances, is being tested in the current corporate climate. Personal liability for directors, including removal, civil damages, and tax liability, as well as damage to reputation, appears not so far from reality as once widely believed. Accordingly, a basic understanding of the director’s fiduciary obligations and how the duty of care may be exercised in overseeing the company’s compliance systems has become essential. Embedded within the duty of care is the concept of reasonable inquiry. In other words, directors should make inquiries to management to obtain information necessary to satisfy their duty of care.

Duty of Care

Of the principal fiduciary obligations/duties owed by directors to their corporations, the one duty specifically implicated by corporate compliance programs is the duty of care.  As the name implies, the duty of care refers to the obligation of corporate directors to exercise the proper amount of care in their decision-making process. State statutes that create the duty of care and court cases that interpret it usually are identical for both for-profit and non-profit corporations.

In most states, duty of care involves determining whether the directors acted (1) in “good faith,” (2) with that level of care that an ordinarily prudent person would exercise in like circumstances, and (3) in a manner that they reasonably believe is in the best interest of the corporation. In analyzing whether directors have complied with this duty, it is necessary to address each of these elements separately.

The “good faith” analysis usually focuses upon whether the matter or transaction at hand involves any improper financial benefit to an individual, and/or whether any intent exists to take advantage of the corporation (a corollary to the duty of loyalty). The “reasonable inquiry” test asks whether the directors conducted the appropriate level of due diligence to allow them to make an informed decision. In other words, directors must be aware of what is going on about them in the corporate business and must in appropriate circumstances make such reasonable inquiry, as would an ordinarily prudent person under similar circumstances.

And, finally, directors are obligated to act in a manner that they reasonably believe to be in the best interests of the corporation. This normally relates to the directors’ state of mind with respect to the issues at hand. In considering directors’ fiduciary obligations, it is important to recognize that the appropriate standard of care is not “perfection.” Directors are not required to know every-thing about a topic they are asked to consider. They may, where justified, rely on the advice of management and of outside advisors.

Furthermore, many courts apply the “business judgment rule” to determine whether a director’s duty of care has been met with respect to corporate decisions. The rule provides, in essence, that a director will not be held liable for a decision made in good faith, where the director is disinterested, reasonably informed under the circumstances, and rationally believes the decision to be in the best interest of the corporation. Director obligations with respect to the duty of care arise in two distinct contexts:

• The decision-making function: The application of duty of care principles to a specific decision or a particular board action; and
• The oversight function: The application of duty of care principles with respect to the general activity of the board in overseeing the day-to-day business operations of the corporation; i.e., the exercise of reasonable care to assure that corporate executives carry out their management responsibilities and comply with the law.

Duty of Loyalty

Duty of Loyalty is a term used in corporate law to describe a fiduciary's loyalty to a corporation.  Section 8.60 of The Model Business Corporation states there is a conflict of interest when the director knows that at the time of a commitment that he or a related person is 1) a party to the transaction or 2) has a beneficial financial interest in the transaction that the interest.

Good Faith

Directors must act honestly and in bona fide. The test is a subjective one—the directors must act in "good faith in what they consider—not what the court may consider—is in the interests of the company... "  However, the directors may still be held to have failed in this duty where they fail to direct their minds to the question of whether in fact a transaction was in the best interests of the company.

Difficult questions can arise when treating the company too much in the abstract. For example, it may be for the benefit of a corporate group as a whole for a company to guarantee the debts of a "sister" company, even though there is no ostensible "benefit" to the company giving the guarantee. Similarly, conceptually at least, there is no benefit to a company in returning profits to shareholders by way of dividend.

Proper Purpose

Directors must exercise their powers for a proper purpose. While in many instances an improper purpose is readily evident, such as a director looking to feather his or her own nest or divert an investment opportunity to a relative, such breaches usually involve a breach of the director's duty to act in good faith. Greater difficulties arise where the director, whilst acting in good faith, is serving a purpose that is not regarded by the law as proper.  Not all jurisdictions recognised the "proper purpose" duty as separate from the "good faith" duty however.

Unfettered Discretion

Directors cannot, without the consent of the company, fetter their discretion in relation to the exercise of their powers, and cannot bind themselves to vote in a particular way at future board meetings.  This is so even if there is no improper motive or purpose, and no personal advantage to the director.

This does not mean, however, that the board cannot agree to the company entering into a contract which binds the company to a certain course, even if certain actions in that course will require further board approval. The company remains bound, but the directors retain the discretion to vote against taking the future actions (although that may involve a breach by the company of the contract that the board previously approved).

Conflict of Duty & Interest

As fiduciaries, the directors may not put themselves in a position where their interests and duties conflict with the duties that they owe to the company. The law takes the view that good faith must not only be done, but must be manifestly seen to be done, and zealously patrols the conduct of directors in this regard; and will not allow directors to escape liability by asserting that his decision was in fact well founded. Traditionally, the law has divided conflicts of duty and interest into three sub-categories:

Transactions with the Company

By definition, where a director enters into a transaction with a company, there is a conflict between the director's interest (to do well for himself out of the transaction) and his duty to the company (to ensure that the company gets as much as it can out of the transaction). This rule is so strictly enforced that, even where the conflict of interest or conflict of duty is purely hypothetical, the directors can be forced to disgorge all personal gains arising from it.   However, in many jurisdictions the members of the company are permitted to ratify transactions which would otherwise fall foul of this principle. It is also largely accepted in most jurisdictions that this principle should be capable of being abrogated in the company's constitution.  In many countries there is also a statutory duty to declare interests in relation to any transactions, and the director can be fined for failing to make disclosure.

Use of Corporate Property, Opportunity or Information

Directors must not, without the informed consent of the company, use for their own profit the company's assets, opportunities, or information. This prohibition is much less flexible that the prohibition against the transactions with the company, and attempts to circumvent it using provisions in the articles have met with limited success.

Competing With the Company

Directors cannot, clearly, compete directly with the company without a conflict of interests arising. Similarly, they should not act as directors of competing companies, as their duties to each company would then conflict with each other.  In practice, it is not wholly unusual to see directors serve for two or more companies in competing fields, but it is tacitly assumed that they may only do so if the companies consent.