Fiduciary Duties of a Board of Directors

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The range of fiduciary duties changes when a corporation goes broke.
The range of fiduciary duties changes when a corporation goes broke. (Image: Jupiterimages/Photos.com/Getty Images)

Directors of a solvent company owe fiduciary duties only to the corporation itself and its shareholders. There are two distinct duties involved: a duty of care and a duty of loyalty.

When a company becomes insolvent, though, the nature of the fiduciary duties of the board of directors shift, and they owe duties both to shareholders and to creditors.

Duty of Care

In a landmark decision, Graham v. Allis-Chalmers (Del. 1963), the Supreme Court of Delaware said that the duties of directors "are those of control, and whether or not by neglect they have made themselves liable for failure to exercise proper control depends on the circumstances and facts of the particular case." This duty requires that the directors exercise ordinary care and prudence in the supervision of the company's management. As Eric J. Pan, a Professor at Cardozo School of Law in New York has paraphrased it, the duty of care is a duty to "beware of red flags" about possible malfeasance among the managers.

Duty of Loyalty

Separately, directors have a duty of loyalty, that is, a duty to act in the best interests of the corporation rather than in their own interest. A director breaches this duty if, for example, he enters into a transaction for his personal benefit that creates a conflict of interest between himself and the corporation.

As the 6th Circuit Court of Appeals put the point in a 2001 decision, "The duty of loyalty requires that the best interests of the corporation and its shareholders take precedence over any self-interest of a director ... that is not shared by the stockholders generally."

Insolvency

When a corporation enters financial distress, the range of the directors' fiduciary duties widens. One common rationale for this is that when a company is healthy, its creditors have a range of contractual and legal rights that they can enforce to protect their own interests, but that when a company is insolvent, the enforceability of those rights becomes itself questionable, and the creditors' interests become equitable in nature.

This doctrine forces courts and directors to grapple with the definition of insolvency. Some courts consider a corporation insolvent (and thus hold that the duties of the directors have widened) only when the corporation is no longer able to pay its debts as in the ordinary course of business they fall due. Other courts employ a balance sheet definition: the company is insolvent as soon as the value of its liabilities exceeds that of its assets.

Sales Transactions

One much-litigated context for the exercise of the fiduciary duties of directors involves the sale of one company to another. The law firm Weil, Gotshal & Manges has stressed this point: "[I]t is advisable, if not imperative, for directors and management of a company to evaluate proposed sale transactions carefully by assessing all the relevant facts and applicable principles of law, including obtaining a fairness opinion or having appraisals conducted of assets to be sold."

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