Generally, corporate officers and directors have a fiduciary obligation to the corporation and its shareholders that requires them to act in good faith, use their best judgment, and do their best to promote the corporation’s interests. Collectively, this set of obligations is known as an officer or director’s fiduciary duty and arises from the legal relationship between the individual and the corporation or shareholder.
An officer or director’s fiduciary obligations under California law can generally be distilled into two duties: the duty of loyalty and the duty of care. With regard to corporate directors, both of these duties have been codified in California Corporations Code section 309(a) which provides:
“A director shall perform the duties of a director, including duties as a member of any committee of the board upon which the director may serve, in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances.”
Generally, officers have the same fiduciary duties as directors.
The Duty of Loyalty
The duty of loyalty requires a corporate officer or director to always act in the corporation’s best interest, and forbids the officer or director from engaging in “self-dealing.” Self-dealing is conduct by a corporate officer or director that involves taking advantage of his or her position in the corporation to benefit his or her own interests rather than those of the corporation or shareholders.
For example, assume John is the CEO of a major computer corporation, ABC, Inc. ABC needs to buy a considerable amount of computer chips to install in its computers, so it begins shopping for a manufacturer. John happens to own a large amount of stock in XYZ, Corp., a manufacturer of computer chips.
John, without notifying anyone of his personal interest in XYZ, uses his authority as CEO to ensure that ABC hires XYZ to produce the necessary computer chips, giving XYZ’s share price a significant bump and, in the process, earning John a nice return on his investment in XYZ.
The type of transaction will not always necessarily amount to self-dealing. Had John disclosed to the board of directors that he held an interest in XYZ, and the board elected to contract with XYZ anyway, John would not have violated any fiduciary duty to ABC or its shareholders. However, because John failed to disclose his personal interest in XYZ, his conduct constituted a breach of his duty of loyalty.
The Duty of Care
The duty of care requires a corporate officer or director to carry out his duties as would any ordinarily prudent person in similar circumstances. For example, a corporate officer or director might violate his duty of care by contracting to buy a company without first conducting due diligence to find out if it is an economically sound decision.
The Business Judgment Rule
California has adopted the Business Judgment Rule which establishes a presumption that a corporate director, in the performance of his or her duties, acts in accordance with his duties of care and loyalty. There are two components to the Business Judgment Rule: (1) the rule protects officers and directors from personal liability as long as they are acting in accordance with the statutory requirements of California Corporations Code section 309; and (2) the rule precludes a court from intervening with management decisions that are made by directors in good faith and with the belief the action is the company’s best interest.
Because officers are more intimately involved with a corporation’s operations than its directors, California courts have been reluctant to extend the Business Judgment Rule to officers. As such, officers should take greater care to comply with their duties of loyalty and care.
Minority shareholders in non-publicly traded companies are particularly vulnerable to majority shareholder oppression. Often majority shareholders are able to marginalize minority shareholders. The majority shareholders are able to manage and control the corporation by electing themselves, family members or friends as directors and officers. Once elected, the board of directors can take actions concerning management, employment, compensation, dividends and other actions which lead to the “freezing out” of the minority owners. Accordingly, directors and officers in closely held corporations are generally held to higher fiduciary duties.
Corporate officers and directors owe substantial duties to the corporation that, if abused, can result in significant legal consequences. Accordingly, it is advisable for corporate officers and directors to consult with an experienced business attorney where there is any doubt as to their legal responsibilities. If you have questions regarding the legal duties and obligations owed by corporate officers or directors, contact a San Diego business attorney today.