DUTIES OF DIRECTOR UNDER U.S. LAWS
By:
Norwen Shahreedha Bin Mohd Ghazali
Associate
+603-21185071
The avowed standard of conduct for corporate officers and directors throughout the United States is that they
are expected to perform their duties “with the care, skill and prudence of like persons in a like position”.
It is desirable as an aspirational matter that directors be prudent, careful and diligent, but for several reasons it
is far from obvious that they should be liable for damages for failure to meet these standards.
First, it is generally in the shareholders’ interest for the directors to accept reasonable risks. Second, courts
have little ability to evaluate the risk / return calculus that directors and managers constantly face.
Finally, directors are not in the same position as a firm’s outside auditors or its investment bankers, who may
serve many firms and can thus spread their risk of liability.
Rather, directors serve at most relatively few firms and this fact may make them poor “cost avoiders” because
they cannot effectively absorb potential liability as a cost of doing business by incorporating it into the price they
charge for their services. Given the inevitability that some risky business decisions will result in failure, the
prospect of judicial “second guessing” might make corporate officials overly risk-averse, to the detriment of
shareholders.
“Business Judgment Rule”
The business judgment rule is a safe harbour for directors. A director's decisions are not subject to review in
court so long as they are made in good faith, on an informed basis, and in the best interest of the corporation
(i.e. absent a conflict of interest). So long as the director's decision is mere "business judgment," they will not be
personally liable for it.
In Shlensky v. Wrigley, 237 N.E.2d 776 (Ill. App. 1968), a shareholder of the Chicago Cubs baseball team’s
holding company attempted to sue Cubs president Philip Wrigley. At the time, the Cubs were the only Major
League Baseball team that did not have lighting at its home field, Wrigley Field. The court refused to force
Wrigley to install lights for night games, stating that "there must be fraud or a breach of good faith which
directors are bound to exercise... in order to justify the courts entering into the internal affairs of corporations."
The business judgment rule can be set aside when directors approve a criminal act in the interest of maximizing
profit. See Roth v. Robertson, 118 N.Y.S. 351 (Sup. Ct. 1909) ("strict accountability" for a director who paid
"hush money" to individuals claiming illegal operation of business); Miller v. AT&T Co., 507 F.2d 759 (3d Cir.
1974) (directors not insulated from liability on ground that an illegal political campaign contribution was made in
exercise of business judgment).
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Duty of loyalty
Directors are required to deal fairly in any transaction that creates a conflict of interest, such as when the
corporation is dealing with the director himself, or another corporation upon whose board the director sits.
Directors cannot take personal windfalls from corporate transactions, and if they run a business that competes
with the corporation, they must do so in good faith. They cannot use corporate assets for their personal
business.
Duty of oversight
1. Business activities
A director cannot be a "dummy" on the board. Each director has a duty to attend meetings on a regular basis
and to keep track of what is happening in the corporation, including its financial status. Directors who do not
fulfill this duty breach their fiduciary duty to the shareholders, and potentially to others; see Francis v. United
Jersey Bank, 432 A.2d 814 (N.J. 1981) (holding negligent director of reinsurance broker liable to clients).
2. Legal compliance
Some courts have held that a director need only investigate possible criminal misconduct within the corporation
if a "red flag" comes up to alert them of the problem. See Graham v. Allis-Chambers Mfg. Co., 188 A.2d 125
(Del. 1963).
Others have held that the Board of Directors must have a reasonable information gathering process in place to
monitor the corporation's compliance with the law. See In re Caremark Intl., Inc., 698 A.2d 959 (Del. Ch. 1996).
Duty to become informed
Somewhat more problematic than the duty of oversight is the duty to become informed. Many courts have
imposed a duty upon directors to actively seek information on any major transaction. One of the most
controversial cases regarding the duty to become informed is Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985),
described below.
The Trans Union case
Van Gorkom was chairman and CEO of the Trans Union Corporation, which made much of its revenue from
leasing out railway cars. Due to tax issues, Trans Union needed to boost its revenues in order to stay
competitive. In September 1980, Van Gorkom sat down with a friend, Pritzker, who specialized in corporate
takeovers. He proposed a sale of Trans Union to Pritzker at $55 a share, and Pritzker accepted this offer
several days later. They worked out a deal over the next few days in which Trans Union's shareholders would
receive $55 cash for each of their shares, and Pritzker would have the option to buy one million shares of Trans
Union's unissued treasury stock at $38 per share, 75 cents above market price. Pritzker demanded a response
from the Board of Directors by the 21st of September, just three days away.
On the 20th of September, Van Gorkom called a senior management meeting. Almost all of the other managers
thought the idea was ridiculous. The CFO objected to the $55 per share price and to the option to buy treasury
shares. Immediately after the management meeting, Van Gorkom summoned the Board. He outlined the deal to
them without handing over the actual agreement. He brought in a lawyer from an outside firm, who instructed
the Board that they might face a lawsuit if they failed to take the offer; after all, it was for a shareholder meeting
to decide. The CFO told the Board that $55 was "at the beginning of the range" of a fair price. The Board
approved the merger offer after two hours, on the condition that Trans Union would be able to accept any better
offer brought within the next 90 days. Van Gorkom signed the merger agreement that night at a party. Neither
he nor any members of the Board had actually read it.
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After the deal was made public on the 22nd of September, many officers threatened to resign from Trans Union.
Van Gorkom quieted them down by negotiating amendments that would allow Trans Union to solicit other bids
through its investment banker, Salomon Brothers. The Board approved these amendments on the 8th of
October. Two other offers came in, but neither could be completed within the 90-day window. On the 19th of
December, a derivative suit was filed. The Delaware Supreme Court overturned the Court of Chancery's ruling
for the defendants, stating that:
Under the business judgment rule there is no protection for directors who have made "an unintelligent
or unadvised judgment." A director's duty to inform himself in preparation for a decision derives from the
fiduciary capacity in which he serves the corporation and its stockholders. Since a director is vested
with the responsibility for the management of the affairs of the corporation, he must execute that duty
with the recognition that he acts on behalf of others. Such obligation does not tolerate faithlessness or
self-dealing. But fulfillment of the fiduciary function requires more than the mere absence of bad faith or
fraud. Representation of the financial interests of others imposes on a director an affirmative duty to
protect those interests and to proceed with a critical eye in assessing information of the type and under
the circumstances present here. Thus, 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.
...In the specific context of a proposed merger of domestic corporations, a director has a duty under
(the law), along with his fellow directors, to act in an informed and deliberate manner in determining
whether to approve an agreement of merger before submitting the proposal to the stockholders.
Certainly in the merger context, a director may not abdicate that duty by leaving to the shareholders
alone the decision to approve or disapprove the agreement. Only an agreement of merger satisfying the
requirements of (the law) may be submitted to the shareholders.
The Supreme Court sent the case back to the Court of Chancery with instructions to determine the fair market
value of the plaintiffs' shares in Trans Union, and award damages to the extent that the fair value exceeded $55
per share. Before this could happen, the directors agreed to settle the claim for $23.5 million, $10 million of
which was paid from liability insurance taken out by the directors, and the remaining $13.5 million paid by
Pritzker.
Chicago business school academics were up in arms over the case. How could directors be liable for approving
a deal where shareholders got a 50% premium over the market price of their stock? And what business did the
court have second-guessing the directors' judgment? Ira Millstein contended that "99% of boards didn't think
that anything wrong had happened. Most everybody wrote about the decision as 'the Delaware courts are going
nuts.'"
On the other hand, the decision put Board members on notice that they had to be careful not to rush to
judgment, especially in deals involving large amounts of money. Millstein again: "If you went into a board room
before Van Gorkom and tried to talk about legal obligations, they'd say 'We have more important things to do...'
When it came down, you were able to walk into a boardroom for the first time and really be heard."
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