Directors - Standards & Liabilities

by Jim Slaughter

Updated from "Board of Directors Duties and Liabilities" in The Business Weekly of the Greensboro News & Record

Congratulations!  You've just been chosen to be a member of the board of directors. Your new position, whether of a for-profit corporation or a non-profit association, is prestigious and well respected. By the way, did anyone describe your duties or the fact that you may be financially liable for your actions?

Standards of Conduct

Boards of directors must have the authority and discretion to manage the organization successfully. At the same time, however, wrongdoing by directors must be prevented. As a result, a balance must be made between a board of director's protection and its accountability.

Both the NC Business Corporation Act and the NC Nonprofit Corporation Act give guidance on the duties and liabilities of directors. Specific standards of conduct are provided. Directors must discharge their duties:

1. in good faith
2. with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and
3. in a manner the director reasonably believes to be in the best interests of the corporation.

Although these standards are vague, they can be generally described as a "duty of good faith" and a "duty of due care."

Good Faith

The primary duty of a director is good faith. This means that directors must perform their duties honestly, conscientiously, and fairly. An entity must be managed in the best interests of all shareholders/members and not for the particular benefit of any group or individual. An important element of good faith is undivided loyalty to the corporate entity as a whole. Directors are prohibited from using their positions for their own personal gain to the detriment of the corporation or its members. Obviously, certain transactions between a director and a corporation are often necessary and even advisable. However, a director should not be involved in such transactions unless the director "reasonably believes [them] to be in the best interests of the corporation."

Generally, a director cannot compete with the corporation. For example, a director cannot usurp a corporate opportunity to the detriment of the corporation. To avoid liability in such instances, the director must establish that the transaction was "just and reasonable" to the corporation because it did not involve an opportunity that the corporation would have wanted. Similarly, a director should not be doing business with the corporation if there are equally good, cheaper alternatives to the corporation. Questions of undivided loyalty can also arise when a director is on the boards of two different corporations that have dealings with each other and have possible competing interests, such as a parent/master and sub relationship.

You will sometimes hear that directors are "fiduciaries" of the association. While the term is probably thrown around too often and in too many situations, the principle is accurate. A fiduciary is someone who supervises or manages assets or property for others and is held to a higher standard of responsiblity (think of a trust officer at a bank). In the same way, directors must look after the corporation's interests more than their own. Directors must give their loyalty to the association and not use the position for personal benefit. FYI, one aspect of loyalty is confidentiality regarding the corporation's business, except for decisions that are clearly intended to be public.

Duty of Due Care

While the duty of good faith prohibits misconduct, the duty of due care creates an obligation to direct and supervise the corporation. The specific language from the Acts is that directors must conduct themselves "with the care an ordinarily prudent person in a like position would exercise under similar circumstances." Inherent in such language is the possibility that some directors are held to higher standards than other directors.

At a minimum, a director is required to see that the corporation is operated according to the terms of its governing documents, including any articles of incorporation, bylaws, and state law. Directors are also under a "duty of reasonable inquiry" to inform themselves as to the condition of the corporation and the conduct of its affairs. As a result, directors cannot claim they didn't know about mismanagement or fraud when reasonable attention would have disclosed the misconduct. This principle has been used to hold directors liable when they delegated management functions to other individuals or committees that mismanaged the corporation. In short, while directors can delegate to others the authority to act, they cannot delegate their oversight responsibility for actions or inactions.

The duty of due care could place an overwhelming burden upon directors, in that it obligates the board both to what they know as well as to what they should know. Because board positions are often volunteer and part-time, directors seldom have the ability to research every issue themselves. To prevent this problem, the Acts allow directors to rely upon the advice of others under certain circumstances. A director can rely upon information, opinions, reports, or statements, including financial statements and other financial data, if prepared or presented by any of the following:

• Officers or employees of the corporation whom the director reasonably believes to be reliable and competent in the matters presented
• Outside advisers such as lawyers, accountants, investment bankers, appraisers, consultants and others as to matters the director reasonably believes to be within their professional or expert competence
• A committee of the board of which the director is not a member if the director reasonably believes the committee merits confidence.

There is no right of reliance if the director has actual knowledge of information that makes reliance unwarranted.

Liabilities

As long as a decision is made in good faith and with due care, directors are usually protected from claims that they should be held personally responsible for mistakes. The idea that management should be protected from unfair reviews of their mistakes in hindsight is known as the "Business Judgment Rule." According to the Rule, a court will not invalidate or hold directors liable for

• a business judgment
• made by disinterested directors
• within the scope of their authority
• in good faith
• with reasonable care and
• not for their own self-interests.

A director held individually liable for an act may have a right to indemnification from the corporation. The Acts have provisions that may requires indemnification to a director who is successful in the defense of a proceeding to which he was made a party because of being a director. In other circumstances, a corporation may, but is not required to, indemnify a director. The corporation documents should also be examined to determine under what circumstances a right to indemnification may exist.

A director should not sit idly by while action is taken at a meeting that violates either the duty of good faith or reasonable care. In fact, a director who is present at a board meeting is usually deemed to have assented to any action from which the director does not clearly and promptly dissent or abstain. As a result, the director could be personally responsible for such actions. Directors who believe an action at a meeting is a breach of their standards of conduct should express their opposition, to be included in the minutes if possible.

Articles are intended to provide general information and are not legal advice or a legal opinion. Specific questions should be directed to an attorney at Law Firm Carolinas or to another lawyer.