In this fourth episode of a six-part series on corporations, I’m going to discuss the
fiduciary duty of care.
This is the duty that requires corporate directors, officers, and employees to act reasonably,
and failure to do so can create personal liability for their breach of the duty.
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This is Professor Baez. Today we are going to begin our examination of fiduciary duties
by looking at the duty of care.
Members on a board of directors are in a fiduciary relationship with the corporation.
Black’s Law Dictionary defines a fiduciary as someone who is required to act for the
benefit of another person on all matters within the scope of their relationship.
Also, one who owes to another the duties of good faith, loyalty, due care, and disclosure.
If a director breaches a fiduciary duty, the director can be sued by the corporation or
by a shareholder of the corporation.
The duty of care requires directors to act reasonably under the circumstances.
Failing to act reasonably under the circumstances results in the director breaching the duty
of care, which we called negligence.
Now over time the courts have created four categories under the duty of care: ordinary negligence,
gross negligence, recklessness, and intentional misconduct.
Imagine that these four are on a continuum.
The least offensive is ordinary negligence, then move to gross negligence, on to recklessness,
and finally the worst conduct is intentional misconduct.
Most corporate negligence falls right over here in the ordinary negligence category.
To protect directors from ordinary negligence,
the courts created a rule that they call the Business Judgment Rule.
The Business Judgment rule exists because the courts realized that the directors are
in the best position to make decisions for the corporation,
and that if this was brought into the courts, basically it would be a substituted judgment
by the judge as to what is or is not reasonable under the circumstances.
So if a shareholder really doesn't like the decisions that the directors are making
they really have a couple of options.
One, they can always remove the board members at the next annual shareholder meeting
or they can sell their stock.
But basically the courts are not going to interfere with ordinary negligence.
Let me give you an example of what I think is ordinary negligence.
And of course people can differ. What is the difference between ordinary negligence, gross negligence?
We'll see in a moment it's degree. But here's one that I think clearly falls in the ordinary negligence category.
So we have three directors: Susan, Juan, and Tim. They are on the board for XYZ, Inc.
The corporation has a million dollars in cash, and they decide that they want to invest
that money rather than keeping it in a bank account.
So they buy the stock of a different corporation, ABC, inc.
Unfortunately, the value of that stock, ABC stock, goes down and the corporation loses $50,000.
The evidence is clear that if they had diversified their stock holdings the corporation would
have made $100,000. Stock market is going up,
and they just made the decision to put all their eggs in one basket.
That's probably negligent, given that we all know spreading our investment makes more sense
than investing into one corporation.
While this may have been, or was in fact a negligent act, an ordinary negligent act.
By that I mean they had a duty and they breached their duty of care.
It's just ordinary negligence.
And since it's ordinary negligence, the courts will not allow shareholders to prevail in
a lawsuit against the directors. The directors are protected by the Business Judgement Rule.
As long as they're acting in good faith, ordinary negligence, that's fine.
Now let's move on to gross negligence. That's sort of over here.
We've now moved from ordinary negligence to gross negligence.
Gross negligence is a bit harder to define because it's really nothing more than bad negligence.
So we've got ordinary negligence and some worse negligence, what we call gross negligence.
But rather than saying it's bad negligence or worse negligence,
let me give you a definition from Black's Law Dictionary.
You're going to see that even Black's is unsure how to define this category.
Here's what Black’s Law Dictionary states:
Most courts consider that gross negligence falls short of recklessness--so something less than recklessness.
But it's more than ordinary negligence. So it's something here in between.
So it's really a matter of degree, not in kind.
In short, there is no generally accepted meaning; but the probability is, when the
phrase is used, that it signifies more than ordinary negligence, but less than recklessness.
Now let me give you an example for the most famous gross negligence case,
out of Delaware, called Smith v. Van Gorkom.
In that case, Van Gorkom was the chairman and CEO of a large corporation.
Someone approached Van Gorkom during the intermission at an opera
with an offer to buy his corporation for $55 per share.
That's a publiclly traded corporation, and frankly,
the price, $55 per share, was significantly higher than the price
the corporation's stock was trading for on the stock exchange.
So Van Gorkom thought it was a good deal, so he took itr to the Board of Directors.
Now here's what he did.
He called for an emergency meeting over the weekend, two or three days notice,
he did not tell the board why they were meeting.
He didn't tell the officers of the corporation why they were meeting.
He did not bother to get any additional financial information, either for himself or for the board.
He never got an independent valuation of the corporation’s value.
And then, when the board met, and he explained to them over 20 or 30 minutes about the deal
the board decided to sell this multi-million dollar corporation during a meeting
that lasted less than an hour.
Under those facts, the court found
that this conduct amounted to gross negligence and, remember if it's gross negligence
the Business Judgment Rule does not apply.
The Business Judgment Rule only applies to ordinary negligence.
The directors were then personally liable for $23 million in damages to the shareholders
for selling the corporation at too low of a price.
Right after the Van Gorkom case was decided--remember, this came out of Delaware.
As I mentioned earlier, Delaware has a very pro-business legislature.
Well the Delaware legislature met and they amended their state corporation law.
And now this change has been adopted by every other State, most other States.
This change allows corporations
to immunize directors for gross negligence. But there's a catch.
So directors are not liable for gross negligence if the corporation has placed appropriate
language in the articles of incorporation.
So the corporation has to go through that extra step.
Here's an example of what a corporation could place in their articles of incorporation:
"The directors are not liable to the corporation for any negligent act.”
So if there's a provision like that inside the articles of incorporation,
now the board of directors are, first under the Business Judgment Rule
they're not liable for their ordinary negligence. And with this type of provision
they're also not liable for their gross negligence.
And most large corporations have adopted this sort of language.
So ordinary negligence, gross negligence, most directors are safe from all their negligent acts.
Now we get to recklessness.
Recklessness is defined as acting with a conscious disregard for the rights of another.
Let me give you an example of a case involving recklessness.
In this case, we have an older woman who became the director of a corporation after her husband died.
It was a large corporation dealing with insurance, and was operated by Dad and Dad's two sons.
Dad dies, Mom takes over as a director.
Before he died, he told his wife, watch out for the two sons. They're bad kids.
They're going to rob the corporation. You gotta keep an eye on them.
After his death she fell into a deep depression, she began drinking heavily.
Needless to say, she completely ignored the corporation. She completely ignored the two sons.
And guess what the two sons did. They proceeded to rob the company blind.
The shareholders sued this woman for breaching her duty of care.
The court found that she acted recklessly by not attending to any business matters at all.
Therefore, she was liable to the shareholders.
So this is an important note to make: a corporation cannot immunize the directors
for reckless conduct or, as we are about to look at, intentional conduct.
So ordinary negligence, covered under the Business Judgment Rule.
If there's a provision in the articles of incorporation, directors can be immunized for gross negligence.
You're on the hook for reckless conduct. You're on the hook for intentional misconduct.
Let's look at intentional misconduct, which is the final category
This occurs when someone desires to commit an unreasonable act.
For example, a corporate director votes to transfer funds to a failing bank, knowing
the corporation is going to lose all of the money.
In that case, the director is liable for this intentional misconduct.
Let me recap.
The Business Judgment Rule protects all directors from ordinary negligence.
Directors are liable for gross negligence, recklessness, and intentional misconduct.
However, if a corporation has a clause in its articles of incorporation dealing with gross negligence,
it can shield the directors from gross negligence.
Finally, a director is never protected for his or her reckless or intentional misconduct.
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