Warning--potential danger ahead! A business judge's starting list of yellow flags for the conscientious independent director.

AuthorStrine, Jr., Leo E.
PositionDUTIES OF DIRECTORS

DO YOU KNOW what standard is typically applied to decide whether a medical doctor is personally liable in a malpractice case? The answer is relatively simple: A doctor can be held liable if he or she did not perform with reasonable care in treating the plaintiff's malady. What kind of standard is this? Simple negligence.

What about a police officer or firefighter? By what standard of conduct can these good men and women be held liable for monetary damages? Typically, public officials making a discretionary decision--such as deciding how much force is necessary to restrain a dangerous suspect--face personal liability if they act with gross negligence.

Now, let's look closer to home. What level of culpability is typically required for a director to be held personally liable? Simple negligence? No, that is not even a cognizable breach of fiduciary duty. Gross negligence? No. Even though that is the legally enforceable standard of care, most directors are insulated from personal liability for gross negligence by virtue of an exculpatory charter provision, authorized by a state corporate law statute like Delaware's § 102(b)(7).

So, what is required for a director to be held liable for wrongdoing? Bad faith conduct. Intentional violations of law. Personal self-dealing. Culpability depends on the director having breached his duty of loyalty, which in the case of a disinterested director will require a showing of scienter--of a culpable state of mind. This is a very difficult showing for a plaintiffs' lawyer to make. It would be rare for anyone to identify a case since Van Gorkom when independent directors have been held liable for monetary damages. Even I cannot, and I am on a court that handles lots of corporate cases.

Does all this mean that independent directors have nothing to worry about in the current environment--that being a director is risk-free? Of course not, and it would be outrageous if it were otherwise. With power comes responsibility, and being the director of a public company is an important undertaking. Most trustees are held to a simple negligence standard. Corporate directors are given far more protection. But independent directors should and will remain accountable if it can be proved that those directors consciously--i.e., knowingly--failed to discharge those responsibilities.

Here is a quick example of the difference between simple negligence and a conscious failure to fulfill the fiduciary duty of care. I have a five-year-old son. Assume James and I go out to bring in the mail. My neighbor is out in his yard and engages me in small talk. I lose track of James and he goes out in the road. That's simple negligence.

Assume, by contrast, that I sit in my front room working on my (nonexistent) personal computer every day and I know--and can even see when I bother to look--that James is playing in the front yard by the road. Is that negligence? No way. I know it's my job to keep James safe and I know I'm not doing it. That is conscious, culpable wrongdoing.

What follows are some warning signals--yellow lights or yellow flags, if you will--that ought to trigger concern and extra caution on your part. By heeding these warning signals, you can better protect yourself as an independent director and, in so doing, better protect the shareholders and other company constituencies whose interests you are duty-bound to consider.

When you see or feel one of these warning signals, you ought to react with heightened sensitivity. I say "see or feel" because some of the warning signals will emerge internally in your head, in your conscience. In fact, some of these signals, when perceived, should cause a little knot in your stomach to form and remain until you're assured that the danger has passed.

  1. Related-Party Transactions

    I start with the most obvious of these signals: Any related-party or conflict transaction should give you pause. Such transactions fundamentally transform the normal environment in which directors make decisions.

    Why? It makes suspect the board's best source of information and advice. Managers know more about the company than anyone, including independent directors. When a top manager or controlling stockholder is on the other side of the transaction, the board's access to impartial managerial advice is distorted. At best, the board will receive the input of other disinterested officers--who for their parts know that they are advising on an issue on which their boss's personal interests conflict with the corporation's.

    This is no easy predicament for a corporate executive, and the implicit (but perfectly obvious) pressures on the executive are often so substantial that the board must seek other sources of advice. Such advice from outside advisers is a second-best substitute for the disinterested advice of company managers...

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