A corporation is a small “republic” with the shareholders (owners) electing the directors who, in turn, appoint the officers who run the day to day operations of the company. Absent a contract to the contrary, the officers serve at the pleasure of the Board of Directors and most Boards are elected annually by the shareholders.
The role of the shareholders is clear: they own the company, enjoy its benefits, and elect the directors. The role of the officers is the day to day operations of the company. The directors are more strategic in nature, supervising generally the operations of the company and the actions of the officers. This article shall explore further the roles of the directors of a California non public corporation.
Basic Duties Imposed by Statute on Directors:
While officers run the day to day operations of the corporation, it is the directors who are concerned with the more strategic operations of the company and who have a direct duty to the shareholders as to the well being of the corporation. They supervise the activities of the officers and report back to the shareholders as reasonably required but no less often than annually. They have a fiduciary duty to the shareholders and the company.
A California non public owned corporate director’s general duty of care is set forth in Corporations Code §309. [1] Corporation Code Section 309 provides as follows:
(a) A director shall perform the duties of a director, including duties as a member of any committee of the board upon which the director may serve, in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances.
(b) In performing the duties of a director, a director shall be entitled to rely on information, opinions, reports or statements, including financial statements and other financial data, in each case prepared or presented by any of the following:
(1) One or more officers or employees of the corporation whom the director believes to be reliable and competent in the matters presented.
(2) Counsel, independent accountants or other persons as to matters which the director believes to be within such person's professional or expert competence.
(3) A committee of the board upon which the director does not serve, as to matters within its designated authority, which committee the director believes to merit confidence, so long as, in any such case, the director acts in good faith, after reasonable inquiry when the need therefor is indicated by the circumstances and without knowledge that would cause such reliance to be unwarranted.
(c) A person who performs the duties of a director in accordance with subdivisions (a) and (b) shall have no liability based upon any alleged failure to discharge the person's obligations as a director. In addition, the liability of a director for monetary damages may be eliminated or limited in a corporation's articles to the extent provided in paragraph (10) of subdivision (a) of Section 204.
The “Business Judgment Rule:”
Corporation Code Section 309 is a codification of the common law “business judgment rule”. Will v. Engebretson (1989) 213 Cal. App. 3d 1033, 1040; Gaillard v. Natomas Co. (1989) 208 Cal. App. 3d 1250, 1264. The business judgment rule recognizes a long standing policy of judicial deference to the business judgment of corporate directors who are presumably better able than the courts to decide whether or not a proposed transaction is in the best interests of the corporation. Will, supra. at page 1033; Gaillard, supra. at page 1264
Under the business judgment rule, as codified, a director is not liable for mistakes in business judgment, made in good faith, in a manner the director believes to be in the best interests of the corporation and which were made with such care, including reasonable inquiry, as an ordinarily prudent person in a like situation would use under similar circumstances.[2] A director’s liability may be further limited or eliminated by the Articles of Incorporation by provisions.[3]
The language of the statue applies expansively to the “duties of a director”. One authority summarized, without citation to case authority, that application of the business judgment rule as codified by §309 arises most frequently in actions seeking to hold corporate directors liable for corporate losses resulting from, among other things, the directors’ failure to obtain adequate insurance on corporate assets, or to protect the corporation against foreseeable liabilities and claimed diversion or waste of corporate assets. [4]
The §309 duty of care includes a duty of “reasonable inquiry. Information that would cause a prudent business person to make further investigation of facts requires the director to make that investigation and take appropriate action or face violation of the fiduciary duty.
The Duty of Loyalty for Directors and Officers
In addition to the statutory duty of care, corporate directors and officers, who participate in corporate management and exercise some discretionary authority, owe the corporation a fiduciary duty of loyalty (Bancroft-Whitney Co. v. Glen (1966) 64 Cal. 2d 327, 345; GAB Business Services, Inc. v. Lindsey and Newsome Claim Services, Inc. (2000)83 Cal. App. 4th 409,420-424.
A public policy …demands of a corporate officer or director,
peremptorily and inexorably, the most scrupulous observance
of his duty, not only affirmatively to protect the interests of
the corporation committed to his charge, but also to refrain
from doing anything that would work injury to the corporation
or to deprive it of profit or advantage which his skill and
ability might properly bring to it, or enable it to make in the
reasonable and lawful exercise of his powers.
Bancroft-Whitney, supra. at 345
Both the Bancroft-Whitney case and the GAB case involved corporate executives who, while still employed, solicited the most desirable employees of their present employer to leave with them to take jobs with their employer’s direct competitor. However, the reasoning and result in neither case turned on that particular fact pattern. The definition of the duty, as set forth above by the Bancroft-Whitney court would certainly seem to encompass the duty to prevent drastic drop in value and other economic damage or waste to a corporation in the event of a director’s or key officer’s death or incapacity, prevention of which is clearly within the lawful exercise of the director’s powers.
The Corporate Opportunity Doctrine would apply to certain of the actions and the article on that topic should be reviewed by the reader.
The fiduciary duty enunciated by the Bancroft -Whitney Court is imposed upon corporate officers as well as directors[5]. At least one commentator suggests that an officer is held to a higher standard of care than a director because he/she may be required to be more familiar with corporate affairs and less able to rely on the reports or other information supplied by others.[6] A higher duty of care on the part of corporate officers was confirmed by the court in Gailliard v. NatomasCompany, supra., which held that an officer’s liability is not limited by Corporations Code §309 or the business judgment rule. The Gaillard court considered the propriety of golden parachutes for various executives approved by the directors of the corporation, some of whom were also officers, who the court referred to as “inside directors.” The Gaillard court reasoned as follows:
We further conclude, however, that, as a matter of law, our review of the conduct of the inside directors is not governed by section 309. The inside directors did not vote on the approval of the golden parachutes or consulting agreement. In securing the payment of these benefits to themselves, they were not "[performing] the duties of a director" as specified in section 309, but were acting as officer employees of the corporation. The judicial deference afforded under the business judgment rule therefore should not apply. As stated by Marsh in his discussion of section 309: "section 309 subdivision (a) does not relate to officers of the corporation, but only to directors. . . . [An] officer-director might be liable for particular conduct because of his capacity of an officer, whereas the other directors would not." (1 Marsh, op. cit. supra, § 10.3, at p. 576.) This result is in accord with the premise of the business judgment rule that courts should defer to the business judgment of disinterested directors who presumably are acting in the best interests of the corporation. Gaillard, supra at p.1265.
The facts upon which the Gaillard court distinguished the activities of an officer/director from the activities of an “outside director” for purposes of liability are the following. The officer/directors were active in the negotiation of the favorable employment agreements and the merger structure that required them. However, when the agreements were put to the full board of directors the five officer/directors who had been involved in their negotiation, abstained from voting. Only the “outside” directors voted.
When determining director liability under Corporations Code §309 there is a rebuttable presumption that a director acted in good faith. Katz v. Chevron Corp. (1994) 22 Cal.App. 4th 1352, 1366; Burt v. Irvine (1965) 237 Cal. App. 2d 828,845. Since the presumption stems from the business judgment rule it would not apply to the determination of liability of an officer. See Burt v. Irvine, supra at p. 845.
Conclusion:
One wag put it succinctly: a director is allowed to be wrong but not allowed to cheat or be wrong without a leg to stand on. Courts will give him or her wide discretion and allow him or her to have made the wrong decision but only if there was some grounds for making such a decision and dishonesty or self dealing was not a factor.
It is equally vital to note that the duty of inquiry does not allow a director to “look the other way” or fail to make reasonable inquiry as to facts or developments that a prudent business person would investigate.
”I don’t want to know” is not a valid defense.
Bylaws can provide additional protection for a director and limit both the exposure and provide for indemnity to a director forced to defend him or herself. But the Courts have been firm that if wrongdoing or gross negligence is demonstrated that the director will not be able to rely on indemnity or the business judgment rule for protection.
Thus being a director requires due care and full understanding of the duties imposed. It is not merely a ceremonial position or a seat around a large table. It is an obligation, a duty, and the shareholders have the right to require compliance with all the obligations of a fiduciary.
[1] Other specific grounds for liability not readily apparent here are Corporations Code §310 [voidability contracts and other transactions for director self interest]; § 315 [liability for approving an illegal loan of corporate funds] and §316[liability for illegal guaranty on corporate credit].
[2] Corp. Code §309
[3] Corp Code § 204
[4] The Rutter Group, California Practice Guide Corporations, section 6:427, p. 6-50.
[5] Bancroft-Whitney, supra. p. 345.
[6] Mathew Bender, California Pleading and Practice, Vol. 14, Chpt. VII. Directors & Management, p.41 , Officer’s Standard of Care, relying upon Galantine & Sterling, California Corporation Laws, Chpt. 6, Management; Duties & Liabilities of Directors and Controlling Shareholders,§6.102