Board Liabilities

Posted on November 20, 2012


Throughout the dialogue about boards (whether they are at the beginning stage, public company, or advisory boards), the liability question has hung over the discussion like a gray cloud. These fiduciary duties loom as foreboding shadows against the backdrop of public companies where nasty words like “Sarbanes Oxley” strike fear in individuals. In order to more accurately assess and address an individual’s fiduciary obligation, we need to take a step back and get some perspective. Assuming we are not discussing companies that are public or about to go public, the liability is real, but not overwhelmingly complicated.

First, as a starting point, each individual needs to determine what his or her actual position is from a legal perspective. Several people may be on a “board,” but this may be merely an advisory board. If such, then the obligations are defined by contract. If a person is a member of a “board of managers” of an LLC, then the duties are defined by the operating agreement as well, with the caveat that certain duty of loyalty obligations are limited, but cannot be contractually waived in certain states such as Alabama. Thus, when we are talking about the fiduciary duties of board members, our discussion is primarily focused on those individuals who serve as members of boards of directors of for-profit and not-for-profit1 corporations.

The first fiduciary obligation for a board member is the duty of care. The textbook definition of the duty of care is the duty to make good decisions and pay attention to the company. In the business context and the day-to-day context of operating a business, the duty of care is tempered by the business judgment rule. The business judgment rule is a line of case law that has developed where the courts have said that they will not substitute their judgment for the business judgment of the company.

The duty of care and the business judgment rule, however, shift when a company enters into a change of control transaction. Without diving into the legal complexities, the fundamental takeaway for individual directors is that a heightened duty exists in the merger context. Counsel should be engaged when an equity transaction occurs and not all stakeholders are going to consent to the transaction.

The second fiduciary obligation for a board member is the duty of loyalty. The duty of loyalty calls upon directors to put the interests of the company and the shareholders ahead of their own personal interest. In the corporate context, the duty of loyalty is one that comes up more often than not. Consider the duty of loyalty in these three settings:

First, the CEO of a customer is put on the board of a small business. The rationale for such a directorship is obvious; a customer’s perspective is vital and will help guide the business. Additionally, by putting an individual in such a position, the customer feels important and the company has a good “in” with their customer. However, the possibilities for conflict are endless. Is the customer required to buy from the company? Do they get favored pricing? Can they buy from competitors? The conflicts exist for both the company and the individual. These arrangements are permissive, but if the conflict is not disclosed and the relationship is governed by arms length principles, ideally with disinterested party’s approval, then both parties are potentially violating the duty of loyalty.

Second, a member of a venture capital firm becomes a member of the board of directors of a portfolio company. Not only is this typical, but it is oftentimes required pursuant to the terms of the investment. Again, the possibilities for conflict are endless as the financial goals of the venture capital firm (to whom the individual owes some duty) may or may not align with the goals of the shareholders generally. In a common scenario, a venture capital firm may want to engage in a dilutive financing which will essentially wipe out the common shareholders. Can the member of the venture capital firm approve this transaction in an unbiased manner? As always, being aware of the conflict, disclosing the conflict, acting in an arms length manner, and getting prior approval from disinterested individuals is the cure for a conflicting transaction.2

Third, and perhaps the most common of all, shareholder owner takes a salary. This transaction happens every day, sometimes in a unilateral manner. It is not per se wrong. If you provide services for a company, regardless of whether or not you are an owner, compensation is necessary. However, it is a conflict when a person who is an owner takes any money except in proportion to his or her percentage interest. One dollar in the pocket of an individual equals one dollar less for the shareholders. Usually these payments are necessary and appropriate for the functioning of the company, but these payments are also probably the leading source of second guesses by dissatisfied parties.

In all of these situations, awareness is probably the single biggest factor in preventing problems and fulfilling fiduciary duty. While conflicts are difficult to work through, they are not unique. They can almost always be worked through. Frankly, although it may be cheesy, if you say “fiduciary” when you are discussing what you are doing as a board member, you may have a better perspective generally and will be able to render better board service.

As a final note, companies will often buy D&O (Directors and Officer) Insurance for their directors. While each situation is unique, this insurance can provide comfort to directors who are concerned about their personal exposure.

Mike Goodrich
Goodrich Law Firm, LLC

1 The not-for-profit world presents some fiduciary concerns – such as to whom are they owed — that are more complex than discussed here. Care should be taken as a board member of a non-profit. The IRS, in particular, is paying close attention to the activities of non-profits and 501(c)(3). This article is certainly not all-inclusive when it comes to obligations of not-for-profit board members.

2 Additionally, in most of these situations, counsel should be engaged to help parties navigate the course. However, when counsel is retained, it is important to note who the attorney represents — the company, the individual director, or another party.