The board of directors of a company can be likened to the captain of a ship. The board, like a captain, is empowered to run the company and usually delegates the day-to-day execution of the board’s plan to appointed officers of the company. In good weather, a captain’s role may seem easy and almost unnecessary. Similarly, in a good business climate, the role of the board of directors may be upstaged by the performance of the company. That does not mean, though, that the board does not remain responsible for the overall direction of the company. In fact, the board owes certain duties to the company at all times. This note discusses the general fiduciary duties that a board of directors owes to the company at all times.
The board of directors and the directors themselves owe two main duties to the company: the Duty of Care and the Duty of Loyalty. These duties require that the board members act as fiduciaries to the company, meaning that they must put the economic interests of the company ahead of their own interests. The responsibilities imposed by these two duties can become complicated when a director wears more than one hat within a company. For example, a director who votes in favor of the company buying an asset from the director may be seen as putting her interests above those of the company because she would be personally benefiting from the sale. This self-dealing could violate the Duty of Loyalty that the director owes to the company. In this instance, the director could be insulated from personal liability for a breach of the Duty of Care if she can show that her actions (i.e. selling an asset to the company) were made on informed basis, in good faith and in the reasonable belief that the decisions were the best for the company. This defense is known as the Business Judgment Rule. The Duty of Care, the Duty of Loyalty and the Business Judgment Rule are discussed in turn below.
The Duty of Care
The Duty of Care, as its name suggests, applies to the manner in which a board member exercises her duties as a director of the company. In Maryland, this duty is set forth in the Corporations and Associations statutes. In short, directors must act:
- in good faith;
- in a manner that the director reasonably believes to be in the best interests of the corporation; and
- with the care that an ordinarily prudent person in a like position would use under similar circumstances.
The first two elements of the Duty of Care are viewed in a subjective manner and require the director to discharge her duties with the belief that she is acting in the best interests of the company. The third element includes an objective standard. The director’s actions are compared to those of what a fictitious, ordinarily prudent person would do under similar circumstances.
In one important area, Maryland law diverges from Delaware law. Under Delaware law, once a business is “in play” (i.e. the board has decided that it is for sale), the board’s actions are subject to higher scrutiny. In Maryland, the legislature has specifically declined to increase the scrutiny with which a board’s decisions will be viewed in the context of a merger or acquisition.
The Business Judgment Rule
The burden is on the person bringing a suit against a board or a director to prove that the director’s decision was not made in compliance with the Duty of Care. If a lawsuit is brought against a director for a breach of the Duty of Care, the director can invoke the Business Judgment Rule as a defense. Under the Business Judgment Rule, a court will defer to the director’s business judgment if those decisions were made on an informed basis, in good faith and in the reasonable belief that the decisions were the best for the company.
Maryland law allows a director to rely on information provided by others when making a decision. That information can emanate from an officer or employee of the corporation, a lawyer, accountant, or even a committee of the board of directors of the company, as long as that director is not a member of that committee. Provided the director reasonably believes that the provider of information is reliable and competent in the matters presented, the director may rely upon such information. However, a director will be found to not be acting in good faith if it can be proven that the director had any knowledge to make the reliance on the information unwarranted.
Duty of Loyalty
The Duty of Loyalty is also contained in Maryland statutes. The Duty of Loyalty requires that a director not place her interests above those of the company in a transaction. This could happen when a director has a relationship with an outside entity that enters into a transaction with the company, when the company enters into a transaction with a director, or when a director takes a business opportunity away from the company. Maryland law provides that these transactions are not necessarily void or voidable, as long as the director “cleanses” the transactions. Under Maryland law, a director’s contract that would otherwise violate the Duty of Loyalty can be cleansed in one of the following three ways:
- The material facts of the director’s interest in the contract are disclosed to the board and the board approves the contract in good faith by majority vote even if the disinterested directors do not constitute a quorum;
- The material facts of the director’s interest in the contract are disclosed to the stockholders and the contract is approved in good faith by the stockholders; or
- The contract is fair to the corporation as of the time it is entered into and it is approved or ratified by the board, a committee of the board or the stockholders.
To return to the seafaring analogy, a board of directors is charged with setting a course for the company and ensuring that the course is followed. The law of Maryland recognizes this important role and protects board if they follow certain rules. In this way, directors can confidently set a course and rest assured that their decisions will survive rough seas.
If you have any questions regarding the role of a board member or about other business matters, please feel free to contact anyone of the members of the firm’s Business & Transactional team.