The Duty of Loyalty

Fiduciary Duties in General - A Heightened Standard

Once we have identified a group of individuals as the directors and officers (or management committee) of the firm, the next question that needs to be asked is, “why bother?” Of course, the company needs a chain of command and someone who can say, "the buck stops here," but what else is implied when we say, "she is a director of X Corp." or, "he is the president of Y Inc."?

We have discussed the answer to this question previously in this course. By singling out a group of individuals as the directors and officers, those who ultimately own the company, the shareholders, have created an agency relationship. In other words, the shareholders, who are the actual owners of the company, have selected these directors and officers as the individuals who will oversee their investment. Since the investors are too numerous to act collectively on their own, they have identified and hired the directors and officers to act on their behalf.

Given the trust and power that the investors have placed in the directors’ and officers’ hands, the law requires that the directors and officers act to ensure that the investors are protected from their own managers. The law in this area, which governs the behavior of officers and directors, has come to be known as the rules of “fiduciary duties.”

Recall, if you can, the analogy that we discussed in the very first section in Chapter 1. There, we said that the Knights of the Corporate Camelot were bound by the "Code of Chivalry." In history, the Code of Chivalry consisted of the rules that knights were required to follow to demonstrate exemplary conduct so that the people would be willing to follow their rule of order. Likewise, the fiduciary duties in the law of corporations are a set of rules for directors and officers that describe the heightened standards of appropriate conduct that are required of corporate managers.

In the next two sections, we will cover the two main fiduciary duties that the law applies to corporate directors and officers. These are the duty of loyalty and the duty of care. Many of the issues that come up with regards to the actions and misdeeds of corporate managers will relate back to one of these two standards. Keep in mind, however, that there are other important fiduciary duties out there, and, when in doubt, a corporate manager will be required by the law to act in a manner that protects the company and its shareholders as well as that manager can under the circumstances.

Defining the Duty of Loyalty

We begin with a definition of the duty of loyalty as a standard for officers and directors:

A director or officer must act in good faith and with the conscientiousness, fairness, morality, and honesty that the law requires of fiduciaries.

Breaking this definition down, we locate the following operative phrases:

"A director or officer must act in good faith..."
“Good faith” is a general legal standard that will come up many times in your legal studies. At its core, good faith is a rather amorphous concept. It means that the individual director or officer needs to act with the best intentions of the company and its shareholders, rather than his own, as the paramount concern. See National Legal Research Group v. Lathan, 1994 U.S. App. LEXIS 33568 (4th Cir. 1994). Of course, fundamentally, the phrase “good faith” is a particular tool of the court, which a judge may use to justify his or her feeling that a director has or has not complied with the letter of the law as announced in the various legal codes and previous decisions of the court.

"...with the conscientiousness, fairness, morality, and honesty..."
This set of terms, which essentially follow their colloquial meaning, covers the gamut of issues that the courts will consider in determining if a director’s actions are in compliance with the law. Individually, the terms might read as follows:

• Conscientiousness – This term generally indicates the obligation of the director to approach her actions with forethought and due diligence prior to committing the company to a course of business. This includes considering how the act will effect the operations, finances, and longevity of the corporation. See Official Comm. of the Unsecured Creditors of Color Tile, Inc. v. Investcorp International, Inc., 137 F. Supp. 2d 502 (S.D.N.Y. 2001).
• Fairness – This term signals the obligation of the director to consider the impact that the company’s actions could have on all of its constituents – i.e., employees, management, shareholders, and the company itself. Whenever a company plans for the future or acts on behalf of its owners, its decisions impact one of these groups vis-à-vis the others. For example, a decision to hire new employees, means additional costs and, in all likelihood, a lower dividend for shareholders. As such, each corporate action must be weighed as to create optimal fairness for all.
• Morality – As vague as it is outside the business world, this term continues to plague corporate executives and the courts. In general, this word helps signal the basic tenet that corporate executives should play by the rules that the courts and legislatures have laid down and obey their conscience when it comes to decisions in the gray area.
• Honesty – One item of the definition that seems to have been forgotten during the later part of the 1990’s, honesty commands corporate directors to report the progress and finances of the company accurately, and not to mislead shareholders or the market in general. See Jackson Nat'l Life Ins. Co. v. Kennedy, 741 A.2d 377 (Del. Ct. of Chancery 1999).

EXAMPLE: In making a determination as to whether a director in question had breached the duty of loyalty to the company by giving information to a competing firm, a judge will usually indicate that the director had breached the duty because he had not acted with morality, honesty, and fairness toward the company of which he was a director.

"...that the law requires of fiduciaries"

As we have discussed previously, the law of fiduciaries as applied to companies has evolved from trust and estate law. Fiduciaries are individuals tasked with carrying out a specific set of duties on behalf of others. As applied in the business context, the directors and officers of the company are fiduciaries for the firm’s shareholders. This is as a result of the situation that places the directors and officers (as the fiduciaries) in a position to manage and preserve the assets of the shareholders (the beneficiaries of the relationship).

Generally, the law requires that fiduciaries act in a professional manner with the duties to protect the assets under their control, and to expand the corporate assets where possible, while keeping in mind the risks inherent in their decisions. In the corporate context, this means that the company’s officers must do what they can to maintain and protect the assets of the company (its client interests, equipment, offices, trade secrets, etc.) while doing what they can to expand the company’s prospects in the future.

EXAMPLE: In a lawsuit brought by shareholders, the shareholders alleged a variety of complaints based on the fact that shortly after the directors of the company chose to sell the company to another firm, the buyer took all of the firm's assets that it wanted and sold the rest quickly below market price before paying a small cash dividend to get rid of the remaining shareholders. In their suit, the shareholders alleged that the old board had violated its fiduciary duties by not properly investigating the buyer.

Also note that the duty of loyalty can even, at times, outlive the officer or director’s tenure with the company. See Cameco, Inc. v. Gedicke, 157 N.J. 504 (N.J. Sup. Ct. 1999).

Breach of the Duty of Loyalty

Breach of the duty of loyalty can occur in a variety of ways. Generally, however, any breach of the duty of loyalty will occur when the director acts in a manner that benefits himself or others at the expense of the company or its shareholders. Such a transaction, known as an “interested director transaction,” occurs when a director or officer with inside information acts in a way that costs the company or its constituents some value that was previously in the company and is now in the possession of the directors. We will speak more about insider trading and interested transactions in a later chapter. For now, simply keep in mind that if the director or officer is benefiting himself from some action by the company, and others – including the shareholders, employees, other directors/officers or the company – are losing value because of that action, the director is in violation of the duty of loyalty. See N.C. Gen. Stat. § 55-8-31.

In the event of an action in breach of the duty of loyalty, the courts, upon shareholder suit, will act to set aside the transaction unless the director can show that the transaction was conducted in complete fairness. This means that unless the director can show that the transaction was fair when entered into, and continues to be fair at the time when it is called into question, then it violates the duty of loyalty. See In re Wheelabrator Technologies Shareholders Litigation, 663 A.2d 1194 (Del. Ct. of Chancery 1995). To determine if the transaction was fair, the courts will likely look for one or more of the following:

• A shareholder vote approving the transaction
• Board approval of the transaction by a strong vote that does not include the votes of interested directors
• A unanimous vote by the uninterested directors if interested directors are necessary for a quorum

Absent any of the above, the court will act to unwind the transaction or otherwise nullify its effect.

Finally, to give a couple of examples of breach, consider the following:

• Competing Ventures – Directors cannot compete with their corporation

EXAMPLE: Alan was a well respected businessman and corporate mogul. As such, he was invited to sit on the board of NewCo as a director. A few years into his board position, NewCo entered into the lucrative electronic toothbrush market. However, another company that Alan had a substantial investment in was also selling electronic toothbrushes. Given this situation, Alan chose to step down as a director of NewCo because he did not want to stay involved in the competing venture and risk violating the duty of loyalty.

• Corporate Opportunity – Directors cannot usurp corporate opportunities. See Broz v. Cellular Information Systems, Inc., 673 A.2d 148 (Del. Sup. Ct. 1996).

Shoppers, Inc. operated a retail grocery business. It was interested in opening a store in Burbville, but had had a very difficult time locating suitable property. Lance, a director of Shoppers, Inc., lived in Burbvillle. While out for dinner one night, a business acquaintance of Lance’s approached him and told him that a plot of land was going to be cleared on the North end of Burbville and that, because of Lance’s position as a director of Shoppers, Inc. and his living in the community, the neighbor thought he could get the property cheap and quickly. Lance, decided that he would buy the property himself and then sell it back to Shoppers, Inc. for a huge windfall profit. However, when he tried to complete the plan, he was sued by shareholders as having violated his fiduciary duty of loyalty by usurping a corporate opportunity.

See Shapiro v. Greenfield, 136 Md. App. 1 (Md. Ct. of Special Appeals 2000).