Corporate Director and Officer Liability — “Discretionaries” Not Fiduciaries

Since my days at the SEC in the 1970s and 1980s and my academic career that started shortly thereafter, it was gospel that corporate directors and officers are fiduciaries. Indeed, that perception has been a fundamental aspect of corporate lore for centuries and remains vibrant today. This belief, however, is not based on reality. Indeed, identifying corporate directors and officers as fiduciaries is a misnomer.

 

My just published Oxford University Press book Corporate Director and Officer Liability — “Discretionaries” Not Fiduciaries seeks to instill reality into the corporate governance framework with respect to the liability of these individuals. Insofar as I am aware, this is the first source to advocate for the removal of fiduciary status for directors and officers. In its stead, these individuals should be deemed “discretionaries.”  This neutral term accurately portrays the status of corporate directors and officers who are held to varying standards of liability depending on the applicable facts and circumstances.

 

That is not to say that fiduciary standards are nonexistent. Indeed, it is true that in certain situations meaningful fiduciary standards apply to director and officer liability exposure. For example, in an interested director transaction that is neither approved by independent directors nor disinterested shareholders, the entire fairness test prevails. As another example, in a going-private transaction where the parent corporation engages in a cash-out merger transaction eliminating its subsidiary’s minority shareholders, the entire fairness test likewise applies unless there was effectively implemented an independent and competent special negotiation committee as well as approval by an adequately informed uncoerced minority vote.

 

In this regard, however, standards of conduct must be distinguished from standards of liability. As Delaware case law and the Model Business Corporation Act make clear, standards of conduct describe what directors and officers are expected to do. Standards of conduct exhort — without the specter of liability — directors and officers to conduct themselves in an exemplary manner. By contrast, with respect to standards of liability, minimal requirements frequently apply. Indeed, at times, courts conflate these standards. The Delaware Supreme Court’s 2021 decision in Zuckerberg provides a vivid example: “Predicated upon concepts of gross negligence, the duty of care requires that [corporate] fiduciaries inform themselves of material information before making a business decision and act prudently in carrying out their duties.” (262 A.2d 1034, 1049-1050 (emphasis supplied)) This sentence is a wonderful teaching source that I use in my Business Enterprise classes as it brings home to the students the rhetoric of sound corporate governance practices contrasted with the reality of lax liability standards.

 

Black’s Law Dictionary succinctly defines the term “fiduciary” as “[s]omeone who is required to act for the benefit of another person on all matters within the scope of their relationship; one who owes to another the duties of good faith, loyalty, due care, and disclosure <the corporate officer is a fiduciary to the corporation>.” This definition is supported by both case law and commentary. But it does not reflect reality. Consider the following to illustrate:

 

(1)  In Delaware, to establish a breach of the duty of care by a director or officer, gross negligence must be proven. As defined by the Delaware courts, gross negligence signifies that the defendant acted with deliberate disregard or reckless indifference. Indeed, in other contexts, grossly negligent conduct may result in the imposition of punitive damages.

 

(2)  To rebut the presumption of the business judgment rule, a disabling conflict of interest or gross negligence must be shown. As Vice Chancellor Laster recently opined: “To hold a director liable for gross negligence requires conduct more serious than what is necessary to secure a conviction for criminal negligence.” (291 A.3d 652, 690 n.21) It thus is easier for a prosecutor to procure a criminal conviction resulting in incarceration than for a plaintiff-shareholder to rebut the presumption of the business judgment rule.

 

(3)  Enactment of director and officer exculpation statutes results in further diminution by requiring a plaintiff to show, when seeking damages, that the defendant director or officer acted with intentional misconduct. Many of these statutes, as evidenced by the Nevada and recently-enacted Texas statutes, extend beyond the duty of care to exculpate for certain breaches of the duty of loyalty. Indeed, even the Model Business Corporation Act permits exculpation for certain loyalty breaches.

 

(4) Interested director transactions, as enacted by many states and as provided by the Model Business Corporation Act, are beyond judicial purview if they are approved by adequately informed and independent directors pursuant to the gross negligence culpability level of the business judgment rule. Provided that these criteria are met, the propriety of even suspect self-dealing transactions cannot be meaningfully challenged.

 

(5) In Delaware and many other states, a corporation may permit its directors and officers to take “specified business opportunities or specified classes or categories of business opportunities.” (Del. G. Corp. L. § 122(17)) The elimination of this aspect of the duty of loyalty can be effectuated without a shareholder vote, such as by a board-promulgated bylaw amendment.

 

(6)  In many states, otherwise meritorious shareholder derivative actions against directors and officers may be dismissed if adequately informed independent directors determine in good faith in their exercise of business judgment (i.e., lacking gross negligence) that the lawsuit is not in the corporation’s best interests. The result is that the alleged underlying misconduct engaged in by a director or officer never is adjudicated.

 

The book contains many more examples of the disconnect between fiduciary principles and the levying of corporate director and officer liability. The recently enacted Delaware, Nevada, and Texas statutes further evidence this dilution of meaningful substantive standards. But the question may be asked “why does it matter?” After all, corporate directors and officers have been called fiduciaries for a long time. The reply is that the law should be truthful, including with respect to the substance of a term that conveys an accepted meaning. Moreover, reasonable persons, especially uninitiated investors, may rely on a term like fiduciary as requiring a greater level of mandatory conduct than in fact exists. Identifying corporate directors and officers as fiduciaries while applying lax liability standards conveys a false portrayal. This false portrayal is inimical to the rule of law, conflicts with reasonable investor expectations, and adversely impacts the integrity of the financial markets.

 

This book hopefully will make a meaningful contribution to the development of the rule of law. Continuing to identify corporate directors and officers as fiduciaries is a fiction that undermines both legal clarity and investor trust. Fittingly, an accurate and neutral term should be embraced — corporate directors and officers are “discretionaries.”