Directors 'And Officers' Duties Of Care And Loyalty

AuthorJames D. Cox/Thomas Lee Hazen
ProfessionProfessor of Law at Duke University/Professor of Law at the University of North Carolina, Chapel Hill
10.11 Burden of Proof of Fairness in Fiduciary Contracts
10.12 Statutory Treatment of Transactions with
Interested Officers and Directors
10.13 The Power of the Shareholders to Ratify
10.14 Actions Against Directors and Officers for
Mismanagement: Corporate, Individual,
and Creditor Grounds to Complain
10.15 Disclosure Obligations Based
upon Fiduciary Principles
§ 10.1 Liability for Imprudence
and Honest Errors of Judgment:
The “Business Judgment Rule
What is the liability of directors for incompetence? Alt hough directors
are commonly said to be responsible both for reasonable care and for
prudence, the formula is continually repeated that directors are not lia-
ble f or los ses du e to im prud ence or hones t erro rs of j udgme nt.1 This for-
mul a is fre quentl y refer red to a s the “ busine ss judg ment r ule.”2 Taken in
its most cynical light, the business judgment ru le means that manage-
ment’s position is vindicated.3
Courts do not measu re, weigh, or quantify directors’ judgments. We
do not even decide if they are reasonable in t his context. Due care in
the decision-making context is process due care only. Irrationa lity is
the outer limit of the busi ness judgment rule. Ir rationality may be the
functiona l equivalent of the waste test or it may tend to show that the
decision is not made in good faith, wh ich is a key ingredient of the
business judgment ru le.4
The above description of the business judgment rule is best under-
stood by disting uishing bet ween the duty of care and the business judg-
ment rule. The former can be seen as embracing a st andard for officer
and director conduct, whereas the latter embod ies a standard of judicial
review.5 The twin features of the business judgment rules application to
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a decision of the directors are that the directors wi ll not be liable for any
losses proximately caused by that decision a nd that the court wi ll not sub-
stitute its judgment or that of the plaintiff for the decision made by the
directors. We can therefore understand judicial incantations regarding the
care obligations of directors and officers as aspirational, even normative.
However, whether the officer’s or director’s departure from an understoo d
norm results in liabil ity (or the court substituting its judgment for that
of the corporate decision-maker) depends on how her conduct is assessed
under the review standard embraced in the business judgment rule.6
In general, courts will not undertake to review the expediency of
contracts or other business transactions authorized by the directors.
Directors have a large degree of discret ion. Questions of value and policy
have been said to be part of the directors’ business judgment, although
their errors may be so gross as to show their unfit ness to manage cor-
porate affairs.7 According to the better view, the business judgment ru le
presupposes that reasonable dil igence and care have been exercised.8 But
are there not, in addition, some lim its on the immunity for losses due to
honest errors resulting from a director’s lack of intelligence, foresight,
and business sense? Hasty action by an ill-informed board will not be
insulated by the business judg ment rule.9 However, directors and officers
do not operate in a world that permits them to have all the information
they would prefer to have before they act. “The need to make judg-
ments with only imperfect information available, and other elements of
risk taking, are often inherent in business decision-making.10 When the
board has not acted in breach of a fiduciar y duty, its members will be
entitled to the protection of the business judgment rule.11
Courts developed the business judgment rule long before state-
ments on directors’ duties were included in the corporat ion statutes.
Even though corporation statutes in most states now contain an express
statement defining di rectors’ duties and omit any reference to a business
judgment rule, courts cont inue to apply the rule.12
§ 10.2 Standard of Care and Diligence
There has been some difference in the la nguage used by the legislatures
and the courts to desig nate the standard of care and diligence required
of the directors of a corporation in t he management or supervision of its
affairs. It is difficult, however, to tell whether the differing standards,
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which have been referred to as “semantic,13 make much difference in
practical application. The particular stat ute’s precise formulation of the
director’s duty of care does not assume great importance in the court’s
judgment whether the director has breached her duty.14
In New York, an early theoretical standard was declared to be t he
care and diligence t hat an ordinarily prudent man would exercise in the
management of his own affai rs.15 The fairer and more satisfactory rule is
that degree of care and diligence that an ordinarily prudent director can
rea sonab ly be expe cted to exe rcis e in a like posi tion u nder simi lar circ um-
stances.16 This standard was adopted by the Model Act, and a great num-
ber of s tat es h ave f oll owed sui t.17 However, in 1997, the Revised Model Act
provision was changed so as to eli minate reference to this negligence-ty pe
standard. Instead, the 1997 version merely provides that “Each member
of the board of directors, when discharging the duties of a director, shall
act (1) in good faith, and (2) in a manner the director reasonably believes
to be in the best interests of t he corporation.”18 The conf lict of s tandards ,
however, may be more apparent than real; in practical applicat ion such
vague abstractions are meaningless, and a judge and jury will necessarily
formulate their own measu ring rods according to t heir own standards.
For example, the changes to the Model Act still refer to “director rea-
sonably believes to be in the best interests of t he corporation,”19 which
still captu res the negligence concept of how a reasonable director would
act under like circumstances. It would be most unfort unate should this
change in wording result in lowering director accountability for breaches
of the duty of care. The 1997 revisions to t he Model Act also brought in a
new section dealing with the standards of liabilit y for directors.20
Directors are to use such care and diligence and give such t ime and
attention as ordinari ly careful a nd prudent persons can reasonably be
expected to exercise on behalf of such a corporat ion under similar cir-
cumstances.21 What is a fai lure to exercise reasonable care and diligence
is always to be determined with reference to the circumstances of the
particular corporation and, to some extent, of the part icular director.
Whether the breach of that duty gives rise to liability depends upon
both a more extreme depart ure from the objective st andard so that the
business judgment rule does not apply, and a finding t hat losses were
proximately caused because of the breach.
The duty of care can be divided into three distinct segments. First,
there is the obligation of directors a nd officers to be attentive to the
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