Standard of Conduct and Standard

¶ … standard of conduct and standard of review in Corporate Law

This study concerns the duty of care in American corporate law vs. The duty of care in Australian corporate law. To fully understand that duty, it waxes absolutely essential to distinguish between roles, functions, standards of conduct, and standards of review.

'role' entails an organized and socially recognized pattern of activity in which individuals regularly engage. In organizations, for instance, roles take the form of positions, such as the position of the director.

'function' entails an activity that an actor is expected to engage in by virtue of his role or position in that organization. Critically, a standard of conduct enunciates the way in which an actor should play a role, act in his position, or even conduct his functions.

A standard of review, on the other hand, states the test that a court should apply when it reviews an actor's conduct - in our case, a director's conduct - so as to determine whether to impose liability, grant injunctive relief, or determine the validity of his actions.

In many or most areas of law, standards of conduct and standards of review tend to be confused among each other. For instance, the standard of conduct that governs automobile drivers is that they must drive carefully, and the standard of review in a liability claim against a driver is whether he did in all actuality and history drive carefully.

Much in the same manner, the standard of conduct that controls an agent who engages in a transaction with his principal is that the agent must deal fairly in all issues, and the standard of review in a claim by the principal against an agent, based on such a transaction, is whether the agent dealt fairly.

In fact, the conflation of standards of conduct and standards of review is so commonplace that it is quite simple to overlook the concept that whether the two kinds of standards are or should be absolutely identical in any given area is a matter of prudential judgment.

In a corporate world situation in which (i) information was perfect, (ii) the risk of liability for assuming a given corporate role was always commensurate with the incentives for assuming the role, and (iii) institutional considerations never required deference to a corporate organ, the standards of conduct and review in corporate law might actually be identical.

In the real world, however, these conditions seldom hold, and in American corporate law the standards of review pervasively diverge from the standards of conduct.

The difference is akin to perfect competition in economics studies: Perfect competition is assumed, but in all realty, perfect competition is never actually ideal, so the theories are subject to various differing parameters within the paradigm of the perfect competition function.

Historically, the two major areas of American corporate law that involved standards of conduct and review have been the duty of care and the duty of loyalty. The duty of loyalty entails the standards of conduct and review applicable to a director or officer who takes action, or fails to act, in a matter that does involve his own self-interest. (This can also be referred to as self-interested conduct.) The duty of care, on the other hand, concerns the standards of conduct and review applicable to a director or officer who takes action, or fails to act, in a matter that does not involve or entail his own self-interest.

Part 2: The Duty of Care in American and Australian Corporations

The Board of Directors at a company, whether Australian or American, sets the policy and direction of the corporation and is given the power and ability to elect and appoint officers and agents to act on behalf of the corporation, declare dividends, and act on other major matters affecting the corporation. In all actuality, the Board is ultimately responsible for the actions of the corporation.

From an even more basic standpoint, a director is a person appointed or elected, according to law, to manage and direct the affairs of a corporation or company. The whole of the directors collectively forms the Board of Directors.

One of the critical factors is the qualification of a director to act on behalf of the corporation. Only a real person may serve as a director. No business entity, whatever the form, may serve as a director.

The one other qualification to be a director in most states in America is one of age. When age is a requirement, the typical limitation is that the director be at least 18 years of age. But this is subject to state law and is not at all governed federally in America.

Directors of a corporation are not required to be shareholders, or reside in the state of incorporation.

The number of directors in each organization also does not really matter. Although not necessarily specifically stated in a state's corporation statute, it is understood that if your corporation has a single person who will be the officer, director, and shareholder, the corporation must still maintain all corporate formalities. A small corporation may have individuals who serve as officers, directors, and shareholders. If there will be more than one director for any corporation, it is best to have an uneven number of directors to promote taking action by majority vote.

Each state's corporation statute will set forth the minimum number of directors allowed. The Bylaws will set forth the number of the directors for a corporation, as well as define majority and quorum for voting purposes.

The initial appointment or election of directors is, to the contrary, extremely important. Directors are either named in the Articles of Incorporation or appointed by the Incorporator on formation of the corporation. After the initial appointment of the Board of Directors, directors will typically thereafter be elected annually. Except for the initial appointment of directors, the election or appointment of directors will be addressed in the corporation's Bylaws.

Interestingly, the Board of Directors itself sets its own compensation. The Board of Directors may vote to pay directors reasonable compensation for the work they do for the corporation. This compensation is separate from any compensation received by a director for work performed as an officer. Directors may receive a reasonable per-diem for attending meetings, which includes travel and lodging expenses, and may also be offered stock options as an incentive to successfully oversee the affairs of the corporation.

Most critically for this examination, there is the issue of responsibilities and duty of care for directors. The most important duty owed by a director to a corporation is the "Duty of Care." Most states define this duty in their corporation statute.

A typical corporation statute in a state either in American or Australia defining a director's duty of care provides that a director's duties must be performed, "with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances."

This duty of care is, as an analyst may assume, very broad, and requires directors to diligently perform their obligations.

At the heart of the duty of care is the business judgment rule. In fact, the "Business Judgment Rule" works in conjunction with the director's "Duty of Care." Under this rule, a director will not be held liable for mere negligence if exercising his or her "Duty of Care." The rule can be stated as, "A director who exercises reasonable diligence and who, in good faith, makes an honest, unbiased decision will not be held liable for mere mistakes and errors in business judgment." The rule protects directors from decisions that turn out badly for their corporation even where the directors acted diligently and in good faith in authorizing the decision.

Linked also to the duty of care is the duty of loyalty. The "Duty of Loyalty" exists as a result of the fiduciary relationship between directors and the corporation. A fiduciary relationship is defined as a relationship of trust and confidence, such as between a doctor and patient, or attorney and client. The nature of the relationship includes the concepts that neither party may take selfish advantage of the other's trust, and may not deal with the subject of the relationship in a way that benefits one party to the disadvantage of the other.

Basically, the bottom line is good faith. A director must perform his or her duties in good faith and in a manner in which the director believes to be in the best interests of the corporation and its shareholders.

Essentially, this duty means that while serving a corporation, the director must give the corporation the first opportunity to take advantage of any business opportunities of which he or she becomes aware that are within the scope of the corporation's business. If the Board of Directors chooses not to take advantage of a business opportunity brought to its attention by a director, the director may then go forward without violating his or her duty. So, essentially, it operates as a right of first refusal.

A lot of critical information on the duty of care and its itinerant duties is located on every Secretary of State website in each state's corporation statute regarding the duties of care and loyalty.

But the discussion until now has dealt (in a lot of practical matters) with large corporations. In a small corporation, the directors, officers, and shareholders may all be the same.

In larger corporations with a larger Board of Directors, it may not be possible for all directors to participate in certain Board decisions. In that case, the Board of Directors may appoint an Executive Committee to handle certain matters.

The grant of power from the Board to an Executive Committee is included in the Bylaws. The grant of power to an Executive Committee can be fairly extensive and can authorize the Committee to act on behalf of the Board and with the authority of the Board. However, Executive Committees typically may not take the following acts without the approval of the full Board of Directors:

The filling of vacancies on the Board of Directors or vacancy on any committee;

The fixing of compensation of the directors for serving on the Board or any committee;

The amendment of the Articles of Incorporation;

The amendment or repeal of the Bylaws or the adoption of any new Bylaws;

The amendment or repeal of any resolution of the Board of Directors which by its express terms is not so amendable or repealable;

distribution to the shareholders of the corporation, except at a rate, in a periodic amount or within a price range set forth in the Articles of Incorporation or determined by the Board of Directors;

The appointment of any other committees of the Board of Directors or the members thereof;

Adopting an agreement of merger or consolidation of the corporation;

Recommending to shareholders the sale, lease, or exchange of all or substantially all of the Corporation's property and assets; or Recommending to the shareholders either a dissolution of the corporation or revocation of the dissolution of the corporation.

Most concretely, the Bylaws will include the authority and limitations for Executive Committee.

A major issue impacting duty of care for directors is conflict of interest. A conflict of interest is defined as a financial transaction of such significance that it could influence the director or officer's judgment. A director is often required to disclose any and all conflicts of interests so that there is no chance that he or she might violate them down the road.

Delaware sets the standard for the American director's duty of care, since so much American corporate law is based on Delaware codes and case law. Delaware corporate jurisprudence has for decades recognized that corporate directors are charged with a "triad" of fiduciary duties: loyalty, due care and good faith. See, e.g., Emerald Partners v. Berlin, 787 A.2d 85, 90 (Del. 2001). Cases explicating the fiduciary duties of loyalty and care are legion. By contrast, the boundaries of the fiduciary duty of good faith remain amorphous. This is the same in Australian corporate law as well.

For instance, here is the general basis of Australian directors' duties:

Directors should at all times employ a reasonable degree of skill, care and diligence in the exercise of their powers and the discharge of their duties.

To ensure that the appropriate levels of care and diligence are met, it is strongly advised that directors:

keep fully up-to-date on what the company is doing;

investigate the impact of any business proposal on their company's business performance and financial standing;

seek outside professional advice when they do not have sufficient information to make a properly informed decision;

question management and staff about how the business is going; and take an active part in business transacted at directors' meetings.

It is unwise for directors to simply agree to proposals put forward by other directors without obtaining some information about the effect of the proposals on the company's business.

The convergence of the American duties as dictated in Delaware case law and the Australian duties is somewhat surprising, since there are potentially significant consequences under the Delaware General Corporation Law ("DGCL") to a finding that a director did not act in good faith.

For instance, under Section 102(b)(7) of the DGCL, a director who did not act in good faith (or who breached his duty of loyalty, engaged in intentional misconduct, knowingly violated the law or derived an improper personal benefit - one of the elements of scienter) is not entitled to be exculpated from monetary liability, whereas he would be so entitled if he breached his duty of care. Similarly, under Section 145 of the DGCL, a director who did not act in good faith is not entitled to indemnification of legal fees or judgments in litigation.

Recent cases from this Court seem to be split over whether the so-called "duty of good faith" is really an independent duty at all, and also over whether it is truly a subset of the duty of loyalty or the duty of care.

Because much of the discussion regarding "good faith" is geared around whether directors may call upon Section 102(b)(7) exculpatory certificate provisions to avoid personal liability, it is worth briefly noting the history behind that section of the DGCL - the Delaware Code.

In the landmark case of Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), the Delaware Supreme Court decided that directors who approved a merger transaction were simply not entitled to the presumptions of the business judgment rule where they spent a very negligible time considering the transaction, had no meaningful financial advice or analysis in doing so, completely allowed the negotiation process to be controlled by one of the company's executives, and did not even have the merger agreement before them when they approved it. Under these extenuating circumstances, the Supreme Court concluded that the directors breached their duty of care and could be held personally liable for the breach, explaining as follows:

A] director's duty to exercise an informed business judgment is in the nature of a duty of care, as distinguished from a duty of loyalty. Here, there were no allegations of fraud, bad faith, or self-dealing, or proof thereof. Hence, it is presumed that the directors reached their business judgment in good faith, and considerations of motive are irrelevant to the issue before us.

We think the concept of gross negligence is... The proper standard for determining whether a business judgment reached by a board of directors was an informed one." Id. At 872-73 (citations omitted).

Under that standard, the Supreme Court discovered that the directors had acted in a grossly negligent fashion in failing to inform themselves adequately about the merger, even though they were presumed to have acted in good faith, and that they therefore breached their duty of care. Australian cases have held very similarly, putting directors in both countries on guard with regard to their duties.

In 1986, Section 102(b)(7) was enacted by the Delaware General Assembly, following a "directors and officers insurance liability crisis and the 1985 decision [of the Supreme Court] in Smith v. Van Gorkom.'" Emerald Partners v. Berlin, 787 A.2d 85, 90 (Del. 2001) (citations omitted).

Without a doubt, Section 102(b)(7) contained "carve-outs" from exculpation for actions or omissions that simply were not in good faith or from which directors received an improper personal benefit, based upon the language of Van Gorkom singling out "bad faith" and "self-dealing" as examples of improper directorial conduct.

But when one jumps in time to 2003, the result is different. In re the Walt Disney Co. Derivative Litig., 825 A.2d 275 (Del. Chapter 2003), the Delaware Court of Chancery ruled that a board of directors acted in bad faith when it approved an executive's employment contract and later approved the termination of that same contract, with the result that the executive received $140 million for just over one year's performance -- performance that was viewed as poor at best.

Australian law agrees on this subject as well: Good faith means that the directors must at least reasonably see that the corporation gets value for its money. Once again, the board devoted very little time to the decisions, lacked any financial advice or analysis, did not have all of the material terms of the contract before it, and left the negotiation of the contract to a long-time friend of the executive. The Court explained its holding as follows:

These facts, if true, do more than portray directors who, in a negligent or grossly negligent manner, merely failed to inform themselves or to deliberate adequately about an issue of material importance to their corporation. Instead, the facts alleged in the new complaint suggest that the defendant directors consciously and intentionally disregarded their responsibilities, adopting a "we don't care about the risks" attitude concerning a material corporate decision. Knowing or deliberate indifference by a director to his or her duty to act faithfully and with appropriate care is conduct, in my opinion, that may not have been taken honestly and in good faith to advance the best interests of the company. Put differently, all of the alleged facts, if true, imply that the defendant directors knew that they were making material decisions without adequate information and without adequate deliberation, and that they simply did not care if the decisions caused the corporation and its stockholders to suffer injury or loss. Viewed in this light, plaintiffs' new complaint sufficiently alleges a breach of the directors' obligation to act honestly and in good faith in the corporation's best interests for a Court to conclude, if the facts are true, that the defendant directors' conduct fell outside the protection of the business judgment rule." Id. At 289 (citation omitted).