Avoiding personal liability as a director.

• Author: Reed, John L.
• Position: SPECIAL REPORT 2004

ENRON, HEALTHSOUTH, WORLDCOM -- these and a number of other recent, high-profile corporate scandals make the news on an almost daily basis, adding to a modern environment of corporate cynicism and distrust. Along with the seeming rash of corporate scandals has come a rising tide of lawsuits seeking to hold officers and directors personally accountable for corporate losses. The claims made in such lawsuits, if ultimately successful, could easily bankrupt most individuals if left without indemnification from the company or adequate D & O insurance coverage. The expense of litigating such lawsuits, even if found to be unmeritorious, can itself be extremely expensive and, if not covered by insurance or paid by the company, something that cannot be borne by most individuals. In addition to the rising tide of litigation, recent legislative reforms, such as the Sarbanes-Oxley Act, and regulatory enforcement actions emphasize increased directorial oversight, involvement and accountability.

Now more than ever, it is important for directors of corporations to understand the legal safeguards available to them and, perhaps more important, the limits of those safeguards. This Special Report provides an overview of several of the substantive and procedural protections afforded to directors of Delaware corporations (and to directors of corporations in states that follow Delaware law)† and the key limitations on those protections.

The Business Judgment Rule

The business judgment rule is the bedrock of corporate governance and the primary substantive protection available to directors under Delaware law. The rule--which is the standard by which Delaware courts review many, but not all, decisions of directors--reflects the legal premise that decisions made by directors who are fully informed and free from conflicts of interest should not be second-guessed by a court.

To benefit from the rule, directors must have satisfied their fiduciary duties in the decision-making process. So long as a director is disinterested and independent (duty of loyalty), reviews and considers all pertinent information reasonably available (duty of care), and does not act with an ill or improper motive (duty of good faith), a court will neither disrupt nor hold directors liable for the results of those decisions, even if the decisions can fairly be viewed by others as "poor business decisions." The business judgment rule recognizes that directors, and not stockholders, manage the business and affairs of a corporation, and it reflects an underlying policy of freedom in directorial decision-making. Although relatively straightforward, the key to understanding and taking advantage of the business judgment rule is understanding its limitations.

Independence and Disinterestedness. As noted, the business judgment rule is applied by courts in reviewing the actions of directors who are both disinterested and independent. Also known as the duty of loyalty, this qualification to the applicability of the business judgment rule requires that directors act in the best interests of the company and not in their own interest or in the interest of another person or entity to whom the directors may be beholden.

As a general rule, Delaware courts consider a director to be "interested" if the director stands to receive a personal financial or other benefit from a transaction not shared equally by the company's stockholders. Non-financial benefits can also create conflicts, the most common of which is entrenchment--i.e., a director's desire for perpetuation of office. Simply stated, directors are generally considered "interested" when they have a unique or competing personal interest with respect to a given corporate decision or transaction.

Equally important is director independence. Most typically, directors are considered not to be "independent" where they are beholden to a person or entity who has a personal interest in the action under consideration. A director may be deemed "beholden to" another where, as a result of personal, professional, or financial relationships or dependence, the director cannot reasonably be thought capable of acting in the best interests of the corporation. In most cases, casual social ties or friendship, in the absence of other factors, will not create a lack of independence; however, close familial or financial ties or extensive professional and social ties may.

Where present or even potentially present, self-interest or a lack of independence may require that a director abstain from the decision-making process or take other steps aimed at ensuring that the director's potential conflict does not taint an otherwise valid exercise of directorial discretion. Other steps may include the involvement of a disinterested and independent committee of directors or stockholder ratification.

Good Faith. Although exceptions to the applicability of the business judgment rule traditionally have focused on loyalty issues (i.e., the existence of an improper pecuniary interest), the requirement that a director act in good faith may represent the largest source of potential director liability in the near future. The law regarding what type of action or inaction will be considered not in good faith is still evolving. However, good faith at present appears to be a catch-all category, denying the protections of the business judgment rule to directors who, although not financially interested in a decision or transaction, act or fail to act out of a motive other than the best interests of the company. Conduct may...