Directors 'And Officers' Duties Of Care And Loyalty

• Author: James D. Cox/Thomas Lee Hazen
• Profession: Professor of Law at Duke University/Professor of Law at the University of North Carolina, Chapel Hill
• Pages: 160-205

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

PART A. DILIGENCE, SKILL, AND CARE; LIABILITY

FOR NEGLIGENCE IN MANAGEMENT

§ 10.1 Liability for Imprudence

and Honest Errors of Judgment:

The “Business Judgment Rule”

What is the liability of directors for incompetence? Although 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 rule 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 distinguishing between the duty of care and the business judg-

ment rule. The former can be seen as embracing a standard for officer

and director conduct, whereas the latter embodies a standard of judicial

review.5 The twin features of the business judgment rule’s application to

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a decision of the directors are that the directors will 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 liability (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 unfitness to manage cor-

porate affairs.7 According to the better view, the business judgment rule

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 fiduciary 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 corporation 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 continue 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 designate 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 the

care and diligence that an ordinarily prudent man would exercise in the

management of his own affairs.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 application such

vague abstractions are meaningless, and a judge and jury will necessarily

formulate their own measuring rods according to their own standards.

For example, the changes to the Model Act still refer to “director rea-

sonably believes to be in the best interests of the corporation,”19 which

still captures the negligence concept of how a reasonable director would

act under like circumstances. It would be most unfortunate 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 ordinarily careful and prudent persons can reasonably be

expected to exercise on behalf of such a corporation 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 particular director.

Whether the breach of that duty gives rise to liability depends upon

both a more extreme departure from the objective standard so that the

business judgment rule does not apply, and a finding that 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 and officers to be attentive to the

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